When oil prices were more than halved from July 2014 to December 2015, the payout demanded by investors on increasingly riskier energy-company bonds shot higher. No surprise there.
But the stain of oil risk sloshed on to other bonds outside the energy space. And as the cost of issuing debt rose, overall corporate financial health was at greater risk, potentially impacting share prices.
fell below $40 a barrel to hit its lowest level in over a decade during that stretch; currently, it has $50 in its sights.
At the same time that oil prices were dropping, the yield spread—it compares the yield differential between typically lower-rated, thus riskier, bonds with higher-rated debt—widened for non-energy bonds, as well. That was a surprise to financial markets and to researchers at the Federal Reserve Bank of New York, who took a deeper look at this counterintuitive market movement in a blog post Wednesday.
On paper, non-energy firms might be expected to benefit from lower energy costs. Think of companies that rely on transportation, where lower prices at the pump can be a boon.
But another phenomenon upstaged the benefits of cheaper energy costs and it is tied to some interesting dynamics in the market.
“We find evidence of a liquidity spillover, whereby the bonds of more liquid non-energy firms had to be sold to satisfy investors who withdrew from bond funds in response to falling energy prices,” said Brandon Li, senior analyst in the New York Fed’s markets group, and Asani Sarkar, an assistant vice president in the bank’s research and statistics team.
Selling those holdings potentially drove down prices and drove up yields (yield and price move inversely), widening spreads to lower-risk bonds.
Read: Worst of high-yield bond defaults is yet to come—blame energy
That means investors were exposed to the energy sector whether they were really exposed to the stocks and bonds directly associated with oil-and-gas companies.
“One explanation is that sharply lower oil prices may result in investors becoming more risk-averse in general, lowering all asset prices. However, even after including measures of investor risk premium in our regression, oil returns remain the dominant factor in explaining changes in yield spreads,” the researchers wrote.
Another explanation is related to the higher illiquidity of energy bonds, as measured by the price impact per $1 million of bond trades relative to non-energy bonds following oil price declines (see the chart below).
“When oil prices fell, bond mutual funds facing redemptions from energy‑sector investors may have found it easier to sell the more liquid non-energy bonds, thus driving up the yield spreads of those bonds,” Li and Sarkar said.
This unexpected relationship may sound familiar. It resembles the credit crunch and contagion risk sparked by auto makers Ford Motor Co.
and General Motors Co.
during the 2008-09 financial crisis. Their downgrades by credit-rating firms increased borrowing costs and dialed up the costs of borrowing for other companies because auto makers posed liquidity risks to the broader market.
Still, there are aspects of this dynamic that still befuddle researchers.
“The high correlation of oil returns and the yield spreads of energy firms in the recent period is another puzzle given the absence of such a correlation in the historical data,” they wrote. “However, after decomposing oil returns into aggregate demand-and-supply-side factors, we find that when lower oil prices reflect weak aggregate demand, higher credit risk may result. It may be that falling oil prices, even if due to supply conditions, affect global financial conditions via their adverse impact on oil companies.”