US BONDS: Running out of energy

BatteryAfter two years of dire performance, fund managers are feeling better about the US high yield bond sector, but only when energy firms are stripped out. David Stevenson reports.

There was a time when energy companies made up 20% of the US high yield bonds market. Companies could afford to be highly leveraged because, of course, the world always needs oil – and with cheap debt in abundance, some energy firms started issuing debt with abandon. In a low-yield environment, the appetite for junk bonds was ravenous and the supply was there to feed it.

US high yield was one of the biggest beneficiaries of the Federal Reserve’s quantitative easing programmes following the 2008 financial crisis. US treasuries reached a post-war record low yield of 1.38% in 2012, which opened the door for yield-starved investors to the high yield corporate market.   

Then came the collapse. From 2014, oil prices halved in a year and those highly indebted companies with lots of paper outstanding felt the strain. Badly. Bonds lower down the credit scale have a higher risk of default, and at the end of last year, Swift Energy became the 42nd oil driller to file for bankruptcy.

With the default rate rising, some asset managers got caught out and had to close their high yield bond funds. Third Avenue Management closed its $800 million junk bond fund at the end of last year and banned its investors from making redemptions because these illiquid assets would have to be sold at fire-sale prices. 

This was the biggest mutual fund failure since the Reserve Primary money market fund in the days after Lehman Brothers’ collapse in 2008.

Thomas O’Reilly, high yield bond fund manager for Neuberger Berman, says that the default rate is going to increase, from 1.8% last year to around 6% this year and next. For this reason, his firm is significantly underweight in the energy and oil sectors, as this is where he expects the bulk of defaults to be. 

However, he adds: “While it is difficult to time the market in high yield, we still believe that 2016 and 2017 will offer attractive returns for investors in US high yield.” 

Prudence would suggest that stripping out energy from a high yield bond fund is a wise move, given the commodity slump. Yet with the recent rally in Brent crude lifting the shares of BP, ExxonMobil, Royal Dutch Shell and Chevron between 10% and 30%, has the market recovered?

“We expect oil prices to continue to trend higher as supply drops and Iran not producing as much as everyone expects,” says Mark Cernicky, managing director of global fixed income at Principal Global Investors. 

Despite this view, Cernicky says that there are opportunities in US high yield if energy is taken out of the equation. “The spread ex-energy still compensates you for the default risk you’re taking. In US high yield there’s not a lot of refinancing risk away from energy and other commodities,” he says.

Given the poor performance of US high yield over the past two years, it’s hardly a surprise that asset managers are taking a defensive position regarding the asset class. These tactics include buying higher-quality debt and investing in shorter maturity bonds. One peculiarity of ratings agencies is that they rate a company’s bonds regardless of their maturity. So if a fund contains highly illiquid bonds that can’t be sold easily, they can be held on to maturity, and it makes sense to invest in the shorter duration bonds as it reduces default risk.

One firm that is currently defensively positioned is Insight Investment, where Andy Burgess is fixed income specialist. Burgess says he’s more positive on European high yield as there are fewer energy and oil names compared to the US. He also says that the European Central Bank’s recent policy decision to buy corporate bonds as part of its quantitative easing programme will push investors down the credit scale into high yield.  

Nevertheless, the right way to invest in US high yield is at the shorter end of the yield curve, where there is much greater visibility about companies’ earning profiles over the next two to three years. “We run a short-dated high yield fund that’s been successful in generating positive returns, despite the vagaries of the high yield market,” Burgess says.

While investment management firms are acting defensively in their high yield policies, companies making up the high yield universe are being conservative, which is pleasing to some investors.  

Sean Feeley, head of US high yield portfolio management at Babson Capital Management, says: “When you look at the fundamentals picture, away from commodities there’s a trend towards conservative financial policies because of the uncertain economic outlook. 

“We see companies that are cautious about spending money on new projects, on hiring, on how they manage the balance sheet.” 

Feeley thinks that single-B-rated companies are the best bet in the US high yield market because they have to be more conservative than higher-rated companies, who might engage in shareholder-friendly activities such as paying out dividends and therefore be susceptible to event risks.

For others, double-B-rated companies are the preferred choice in US high yield. Burgess of Insight Investment prefers this rating for bonds as part of his conservative stance – although he does say generalising about a credit rating band is no substitute for choosing individual names.

At the moment, US high yield returns 8.6% a year, although with energy stripped out, the yield is 7.5%. However, the default rate has to be included in this, which is why most managers are cautious about the asset class. But in February alone, there were $1.5 billion of inflows into US high yield following outflows of $4 billion the month before. 

It seems the best way to play this market is through active management, despite the fact that a large portion of the February inflows came through exchange-traded funds. As David Will, senior investment consultant at JLT Employee Benefits says, institutional clients like UK pension funds can access active management at a reasonable level and the cost difference between active and passive are not as stark as those found in equities. 

US high yield is about picking the right names and at the moment these don’t include many energy players. But with US high yield up 4% year-to-date, it seems that in this low-return environment, high yield is an asset class that should not be dismissed, despite its recent chequered past.

©2016 funds europe



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