Financial markets across the globe have been dealt a one-two punch—the spread of the coronavirus and an oil price war that caused prices to plummet. Glenn Voyles, Matt Fey and Bryant Dieffenbacher of Franklin Templeton Fixed Income examine the impact on high-yield credit.

US high yield (HY) spreads have widened significantly over the past few days, to levels last seen in early 2016, with likely further spread widening to come. The selloff is a result of simultaneous negative shocks to demand and supply.

The spread of the novel coronavirus (Covid-19) has increased the downside risks to the fundamental picture for the US HY market. While much uncertainty remains, a prolonged period of economic disruption could impact a broad cross-section of issuers in the asset class and drive up the default rate, albeit from historically low levels.

Compounding the situation is the plunge in oil prices in the wake of the collapse of talks between members of OPEC+1 and the subsequent price war between Russia and Saudi Arabia. If current oil prices persist, a majority of the issuers within the HY exploration and production (E&P) and energy services industries could be at risk of default over the longer term.

To put things in perspective, energy is the largest sector in the US HY market, constituting approximately 11.5% of the BAML High Yield index.2 Bonds of certain HY energy companies, especially those in E&P and energy services, are trading down significantly on the back of the 33% decline in West Texas Intermediate (WTI) crude oil prices since Thursday, March 5.

Looking ahead, the outlook for the HY sector will be largely dependent on the duration of both the coronavirus outbreak and the oil price war. Outside of energy, most HY issuers are starting from a position of strength with respect to their balance sheets, given the high amount of refinancing activity and focus on deleveraging in recent years, and so they should be able to weather a quarter or two of depressed operating results and limited capital markets access. We believe the steep decline in oil prices and interest rates should provide further support to many non-energy HY issuers.