Recent press reports concerning several distressed-debt funds liquidating or gating redemptions caused significant volatility within parts of the high yield sector. In our view, a large part of this selloff was due to a “sell first, ask later” mentality that has characterized investors since the global financial crisis, and is now immortalized in Hollywood’s latest cinematic feature, “The Big Short.”

Given investor skittishness, one should expect a potential rush for the exits when concerns arise about fund liquidity and failure to meet redemptions, even if such a rush is driven more by fear than by fact. Yet the bulk of this selloff has been confined to commodity-related issuers, such as energy companies (Exhibit 1), whereas the high yield bond market encompasses a far wider range of issuers overall. (High-yield spreads have widened overall and are back to their 2013 levels, since such sectors as energy, metals and mining are being priced for much higher credit risk. This means that most other high-yield sectors enjoy better risk pricing than they did in 2013.)

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We believe that the high yield funds currently experiencing redemptions are suffering from particular issues. For one, these are relatively small funds invested in distressed or very high risk debt. That part of the corporate-bond market tends to be the least liquid and most risky. The good thing is that these fund investments tend to be made without leverage, which triggered fund failures in 2007, and caused a ripple effect throughout the financial markets. Regulation has partially reduced the risk of contagion, but the financial risks of overly indebted corporations with shrinking revenues—and their implications for debt instruments—remain.

Echoes of 2002, not 2007

We believe there is reason to be concerned with the recent performance of distressed debt, but not because of the possibility of contagion in the financial sector leading to another crisis. Our worry is that poor distressed-asset performance, particularly in important sectors like energy, could be a precursor to a default cycle of the kind witnessed during the early 2000s. And while we believe that such a default cycle is unlikely, it’s possible that many investors will shy away from the high yield market altogether, given the many companies involved in commodity extraction that have issued high yield bonds to fund unprofitable ventures. Such a scenario would be analogous to the indiscriminate pummeling of telecom bonds and stocks in 2002.

Back in the late 1990s there was a massive investment boom by telecom companies, funded in large part by the issuance of debt securities (i.e., corporate bonds). After issuing significant amounts of debt to buy wireless bandwidth and hardware, some investment-grade issuers were downgraded to high yield and investors feared that others would follow. The amount of telecom companies below investment grade swelled and made up a quarter of the market in 2000.

This large sector sent asset prices tumbling amid a risk-off environment. Telecom companies began to experience defaults and drop out of the high yield bond index. Their defaults had a lasting economic impact and the economy remained weak. Finally in late 2002, credit spreads rallied as the economy recovered, but the summer of 2002 saw the widest spreads.

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Eventually a few, like WorldCom, defaulted. The market swooned as a recession took hold and defaults mounted. Eventually in 2002, the U.S. default rate peaked at 10%.

Today’s energy and related sectors like metals and mining are seeing similar issues. Falling revenue, caused by weak commodity prices following a significant investment boom, has generated losses in some investor portfolios that held the debt of those issuers. However, the environment in the energy sector today differs from that observed in the telecom sector in the early 2000s telecom era.

For one, the energy sector constitutes just over 10% of the high yield bond market. Also, as Exhibit 3 shows, high yield credit spreads have only recently reached 600 basis points, the level at which credit spreads remained during 1999-2002. So, if the current situation were to rhyme with that of the 2000s, we could be observing a new equilibrium in credit spreads.

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The current swoon in the energy sector is a concern. Yet, barring a recession, we do not expect contagion to spread to other sectors. Additionally, we believe declining valuations among high yield bonds could be creating investment opportunities in discounted assets. Defaults so far has been limited to commodity-related sectors and remain at relatively low levels (Exhibit 4).

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OppenheimerFunds has Increased the Average Credit Quality in its High Yield Strategies

The high yield energy sector is down nearly 14% so far this year, while distressed—or CCC-rated—debt is down nearly 27%, as measured by the Credit Suisse Liquid High Yield Index (Exhibit 5). With oil and other commodity prices recently hitting new lows, the performance of these sectors will remain in doubt. A potential strategy for those interested in the high yield market is to remain diversified and invested with a manager who seeks to avoid sectors when risks begin to emerge.

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Oppenheimer Global High Yield Fund and the high yield portion of the Oppenheimer Global Strategic Income Fund have focused all year on increasing their exposure to quality segments of the high yield market. These Funds currently have significant underweight positions in the energy, metals and mining sectors. Thanks largely to this decision, the Funds’ performance to date in 2015 is in line with many major high yield indices.

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