The Good and Bad of Falling Oil Prices for Investment Grade Corporate Bonds

Investment Grade (IG) corporate bonds are feeling stress from plunging oil prices. Before August, IG corporates outperformed similar-duration credit-risk free Treasury bonds. Since global growth concerns emerged in September and oil prices began their precipitous decline in October, IG corporates have underperformed, bringing the year-to-date excess return down to about minus 50 basis points, with energy being the worst hit sector, underperforming by greater than 160 basis points. The price of oil impacts energy corporate profitability, which makes its way back to balance sheets via retained earnings. Lower oil prices mean less cushion to absorb economic strain and, hence, higher yields (i.e. lower bond prices). On the opposite side of the same coin may be retailers. Lower oil prices translate into lower shipping costs for online retailers like Amazon.com and also for discount and mass retailers like Wal-Mart. Moreover, consumers have additional (and unexpected) discretionary income from lower gas prices, which the Federal Reserve recently likened to a tax cut. Retail corporate bonds have outperformed the broad corporate index by about ten basis points, year-to-date. With the price of oil likely to remain low for some time due to a supply glut and lower demand (two weeks ago the International Energy Agency lowered its forecast for demand growth next year), we decided to exit the sector by selling our Schlumberger holdings, which outperformed the broader energy sector this year due to superior credit quality. By rotating into Wal-Mart, a name with roughly equivalent credit quality, we aim to reduce exposure to commodity volatility while benefiting from incremental return potential. 
  
Sources: Federal Reserve, WSJ, Bloomberg, BAML Indices, IEA, SNWAM Research