Oil's Slippery Slope, and Why it Matters

As many of you are most likely aware, Oil prices have been on a slippery slope for over a year, sliding from near $100 a barrel in mid-2014 to just below $40 currently. What you may not be totally aware of is why this matters to you and your portfolio.

Many years ago I had a mentor who would often say, “You don’t get bit by the snake you see”. This is so true in the world of investing. After all, it’s not what you know that usually bites you; it’s what you don’t know that you don’t know which usually bites you (boy, that was a mouthful). For all you scholars out there, it is the same concept Frederic Bastiat wrote of in his 1850 essay What is Seen and What is Unseen” . As Bastiat portrayed in his essay, in most situations there is what you see and then there is what you don’t see and it is the things you don’t see that tend to have the greatest influence on future outcomes.

For example, when oil prices decline what you do see is lower gasoline prices which frees up some extra cash in your pocket to go spend somewhere else, like McDonalds to get their all day breakfast, or Starbucks to overpay for some tattooed pimply adolescent to serve you a bitter cup of joe. What you may not see is how the decline in oil prices may be affecting the Fixed Income part of your portfolio. 

Yes, that is right. I said the Fixed Income part of your portfolio. How? You ask. How can lower oil prices be bad for the bonds in my portfolio? The answer lies within what may be the unseen. As interest rates have declined over the past few years, more and more investors have been starved for yield and income. As a result, more advisors and investors have turned to Corporate Bonds, High Yield Bonds and Master Limited Partnerships to boost their income levels. What those unassuming advisors and investors may or may not have known when they invested in that fund with the title of “Strategic Income”, “High Yield” or “Corporate Bond” is that a fairly large portion of higher yielding funds had to include sectors that pay higher incomes in order to attract eyes of potential investors. This stride for yield inevitably led them to the Energy and Basic Materials sectors, which are two sectors known to pay higher yields because the companies associated tend to carry higher debt loads and therefore have lower credit quality and higher risk than other sectors. Not to mention their business revenue is directly affected by the price action of a commodity. As a result, many of these higher yielding fixed income (bond) funds become influenced by the price fluctuations associated with the underlying commodity. Since a picture says a thousand words, let me show you what I mean with a graph. 

As you can see by this side by side graph of JNK, a popular high yield fund and OIL, a fund that tracks the price of oil there has been a correlation between the two. This matters because many investors may have just been bit by a snake they didn’t see.

As many commodity prices have declined over the past few months, more and more investors are being affected in ways they may not have been aware of.

Now, what is important to watch for is whether there is contagion to this problem or not. Do the losses in one sector cause managers to sell in other sectors as the adage “if you can’t sell what you want, you sell what you can” will most likely become a popular mantra in the near future if there is to be contagion in other portions of the high yield market.

This is worth mentioning as the seeds of a potential opportunity may be in the workings for investors with the right risk tolerance and time horizon. If there is to be contagion it would be reasonable to expect additional discounts in other areas of the high yield market and while I acknowledge that as of this moment the train hasn’t left the station in the intended direction, it may be worth your while to pay attention to the high yield and corporate bond markets more closely over the next few months as it is starting to feel like more than one person in the room has the sniffles.

Join us for our next event on January 14, 2016 where we will discuss, “5 Things You Need to Know for 2016”.

Warm regards, Colby McFadden

 

The opinions expressed are those of Colby McFadden and Quiver Financial as of December 23, 2015 and are subject to change due to market or other conditions. This is not a solicitation or recommendation of any investment; always consult a Financial Advisor before investing into any investment. Securities offered through Newport Coast Securities, Inc. - Member FINRA / SIPC - Advisory Services Offered through Newport Coast Securities, Inc. 18872 MacArthur, 1st Floor, Irvine, CA 92612 - 800.992.5592