NEW YORK – Oil's slump didn't just hit the stock market, it's shaken up the junk-bond market, too.
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High-yield bonds are on track for their worst drop in a year and a half after investors dumped risky securities issued by energy companies. Those bonds make up about 13 percent of the category.
The Barclays U.S. high-yield corporate bond index, a benchmark for the securities, has dropped 2.5 percent this month, after a 1.4 percent drop in November. If the index were to end December at that level, it would mark the biggest two-month slump since June 2013.
By comparison, a broader Barclays index tracking the entire bond market, which includes corporate bonds with better credit ratings and Treasurys, is largely unchanged over the same period.
Junk bonds pay higher interest rates than U.S. government bonds and other kinds of corporate debt because they are considered at greater risk of defaulting on their debt. That's because the companies that sell them generally have high amounts of debt in comparison to their income.
The debt has been a favorite for investors who wanted higher levels of income. For energy companies trying to rapidly expand during the U.S. oil and gas boom, the junk-bond market had offered a way to bankroll their operations, even if they had weak credit.
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Investors are now worried that a near 50-percent fall in oil prices will make it harder, if not impossible, for these companies to generate enough earnings to repay their debts. The market, which had an extremely low rate of defaults when oil traded around $100 a barrel earlier this year, is now looking much riskier with prices below $60.
It's not just energy company bonds that are falling. The slump in those bonds has made investors re-evaluate their other holdings of other high-yield bonds.
"You are starting to see energy and energy-related companies that have really re-priced in the last month, and that has weighed down on the market," said James Keenan, head of Americas credit at BlackRock. In the past week, you've seen "more pressure on other parts of the market."
The market for risky debt was already on shaky ground this summer. With the Federal Reserve keeping its benchmark interest rate close to zero for more than six years, investors had been hunting for higher rates.
As bond prices rose, yields fell. In the case of junk bonds, the average yield fell from nearly 22 percent in November 2008, two months after the collapse of Lehman Brothers, to a record low of 5.7 percent this summer.
The robust demand for the bonds pushed yields down to record lows this summer. Investors started to become nervous that the risks of owning these securities was starting to outweigh the benefits.
Popular exchange-traded funds which invest in high-yield bonds are reflecting the slump. iShares' High Yield Corporate Bond ETF has dropped 1.3 percent this month, according to FactSet prices. State Street's comparable ETF is down 2.1 percent in the same period.
The sell-off should serve as a "wake-up call" for investors who had been buying the securities for the income while ignoring the risks, said Collin Martin, a senior Research Analyst, Fixed Income, at the Schwab Center for Financial Research.
"This is a reminder that it is a very risky asset class that is prone to very severe selloffs," Martin said.
The high-yield sell-off this month has been so severe that about one third of high-yield energy bonds are now trading at "distressed" levels, according to Martin Fridson, Chief Investment Officer at Lehmann Livian Fridson Advisors LLC. That means that investors are demanding these companies pay them a yield that is at least 10 percent higher than the yield on a relatively safe U.S. Treasury as compensation for the risk.
Rising yields also imply that investors are expecting more defaults in the energy sector in the coming months and years as the impact of lower oil prices feeds through to the bottom line of companies in the sector.
The ratings firm Standard & Poor's said in a report published Dec. 11 that it expects an increased number of defaults from oil exploration and production companies if oil prices continued to slide.
The average yield on U.S. junk bonds has now climbed to 7.1 percent, the highest level in more than two years. That compares with about 2.3 percent for the broader bond index.
Despite the recent slump and the subsequent rise in yields, analysts say the sell-off may still have some way to go and investors looking to buy at bargain prices might be better off waiting.
"We don't think the sell-off means investors should get in just yet," said Martin. "In 2015 it could create opportunities, but rather than trying to time the bottom, we'd rather let the dust settle a little bit."