The energy sector dilemma for high yield debt investors
The author is a fixed income portfolio manager at Barksdale Investment Management and co-author of “Undiversified: The Big Gender Short in Investment Management”
The high yield bond market has just experienced an extreme cycle of energy downturn and debt boom.
Or, depending on your time horizon, last year’s price swings were just one part of a series of sharp price round trips in a much longer cycle as much of the industry energy shrinks towards obsolescence. The history books of the market are still being written.
For the uninitiated, businesses become high yielding (or less charitable but more precisely, “unwanted”) in one of two ways. They issue bad rated bonds or their debt is downgraded from investment grade to high yield because they are going through a rough patch, becoming what are called fallen angels.
Although students leave Finance 101 knowing that debt-laden balance sheets shouldn’t coexist with volatile commodity prices, the high-yield market supported this cash-searing industry for years before oil and gas prices. gas did start to decline in 2014.
Exploration and waste generation bonds generated a negative return of 30% in 2014-2015, a period that saw more than 20% bankruptcy of the high-yield energy sector.
When experts showed the high yield ânon-energyâ index returns in 2015, it had nothing to do with environmental, social and governance issues. Rather, it was to demonstrate the underlying health of the rest of the market.
It was no wonder the energy sector industry suffered so many flaws after the underwriting frenzy, investors said after the dust returned in 2016. “We won’t make this mistake again” was the chorus.
But sometimes high yield investors are asked to correct the mistakes of others. We were not consulted on the initial funding for Occidental Petroleum, for example. But he became the second biggest fallen angel of 2020 and the biggest emitter of unwanted energy by a factor of four in March of last year.
Suddenly, as a result, here is $ 40 billion of really cheap bonds in high yield territory for us to analyze. A significant part of the performance of high yield securities as an investor depended on this good result.
Junk energy has returned 82% since the low point of the pandemic, compared to 28% for the Bloomberg US Corporate High-Yield Bond Index. As one of the largest high-yielding industries, with a weighting of 13% in the industry benchmark, a portfolio manager ignores it at their peril. By comparison, energy accounts for 8% of the premium-grade market and about 3% of the S&P 500 Index. You could argue that the high-yield market is where energy companies are going to die.
Or, to resuscitate. As risk appetite improved, high-yield investors loaned Occidental $ 10 billion in 2020 at increasingly lower coupons, allowing it to refinance its debt with maturities of 2021-2022. Occidental’s 3.5% 2029 bond now trades 2 percentage points or less against U.S. Treasuries – not far from an investment grade valuation.
Blink once and you might miss this high output transmitter, along with several other fallen angels. The upgrade cycle will leave a big dry well in our market. In retrospect, a relevant history lesson was the 2008 bank downgrade cycle, which saw billions of hybrid bank bonds enter the junk index at pennies on the dollar – and in some cases rebound with yields. of 10 times.
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Now, when clients reasonably ask for an energy thesis, none of the answers are satisfactory. Divest and forgo the additional return of around 0.6 percentage point offered by the industry over the market benchmark? Wait, for the last piece of appreciation as the fallen angels return to the investment grade? Do you want an ESG fund management mandate that takes you away from the decision?
A more difficult question is: will high-efficiency energy matter in five years? Or will we see a massive cycle of fallen angels as the world takes seriously the fight against climate change that makes the West look like a dress rehearsal? Recall that the Big Three American automakers and American department stores once had an “A” credit rating.
Based on our experience in various industries that have made their way into our world, unwanted investors are uniquely placed to point out that this energy cycle is far from over. There will be money to be made throughout the non-linear transition to a greener world (some are already doing this).
Don’t reassign new coverage from your High Yield Energy Analysts just yet. They may have a few dry years, but the likelihood of finding oil as this cycle continues is high.
Barksdale may hold interests in the companies mentioned