Exploring for High Yield Energy Opportunities Amid Ailing Oil Prices
Energy is a popular topic of conversation in the high yield bond space, with many observers warning of a wave of defaults to come due to the plunge in oil prices. While there will likely be some defaults in the sector, we believe that the market’s pessimism has been overly broad, and we view energy as a potential source of opportunity in 2015. Having a clear understanding of macro drivers in energy, paired with careful security selection, will be key to successfully navigating this volatile space, in our view.
Our evolving view of energy
Invesco High Yield Fund was underweight energy in July and August of 2014. At that time, oil prices were around $100 per barrel (compared with about $49 today).1 However, our negative outlook was attributed less to expectations that oil prices would plummet and more to our belief that a number of energy-related bonds had become overvalued relative to their fundamental profiles.
Today, after the oil price plunge and market sell-off, we again see a disconnect between valuations and fundamentals — but this time in the other direction. We have become more constructive on select industries and issuers within the energy complex, despite what has been a challenging time overall for oil. We believe selected bonds have been oversold by a panicked market and represent a potential opportunity to help drive portfolio outperformance. Through careful analysis and discriminating security selection, Invesco High Yield Fund has recently moved back to a neutral weight in energy.
Ranking the energy sub-sectors
High yield energy is dominated by four major sub-sectors. If we ranked them on our view of pure standalone industry credit risk, we would currently categorize them in the following order from the least risky to most risky: midstream (such as pipelines), refiners, exploration and production companies (E&P), and service and supply companies (servicers). However, as investors, we constantly pair fundamental profiles along with market valuations to determine our best opportunities. This ongoing evaluation has led us to the following views:
- Midstream and refiners represent a very small portion of the high yield bond market. Additionally, they have not been dramatically affected by the oil price plunge and thus represent less of a compelling investment opportunity in the near term, in our view.
- While servicers are a larger portion of the market, we are structurally more negative on this sector as these companies have less control over their own futures. This sector is heavily dependent on the spending decisions of their E&P clients and has been decimated by the aggressive cuts in E&P budgets in response to the downward move in oil. We believe it will take more time for this sector to recover given challenging fundamentals.
- E&P companies are the largest part of the high yield energy market (accounting for about 60% of the benchmark)2 and we believe select E&P firms now provide a more attractive risk-reward profile for investors following last year’s selloff. Within this segment, we are most constructive on BB-rated bonds (which represent higher quality in the high yield space) that we believe would be able to weather the storm, even if oil prices were to stay below $60 per barrel for a prolonged period. Characteristics we look for include a skilled and experienced management team, solid liquidity profiles, balance sheet flexibility, and a strong geographic footprint of assets.
We believe selected E&P companies have a number of ways they can raise liquidity if needed, including asset sales, mergers and acquisitions, issuing second-lien debt, and securing longer-dated debt through debt exchanges. Not all of these methods are created equally — we would prefer to see an asset sale or a merger with a financially stronger buyer versus taking on additional debt — but these are all valid pathways that selected E&P companies can use to navigate a prolonged lull in oil prices. Already, we are beginning to see quality bonds in this sector rebound from their lows.
Location, location, location
In energy, as in real estate, location matters a great deal. We favor companies that are focused on onshore projects versus those that are dealing with harsh conditions offshore. Specifically, we favor projects in Texas’ Permian Basin — these wells can maintain production longer than those in other basins, and the fields are conveniently located close to refineries. (In contrast, oil from the Bakken formation, which stretches across North Dakota and Montana, must be shipped cross-country by rail to be refined into usable products such as gasoline.) In the Permian Basin and other favorable locations, companies can profit even in an oil price environment of $65 to $70 a barrel.
Conclusion
Between now and July, we believe oil prices could test new lows into the low-$40 per barrel range due to a glut of supply. However, the market forces of supply and demand are likely to correct themselves over time, so we do not believe such low prices are sustainable in the long run. The question, however, is how that timing will play out. The Invesco High Yield team is focused on companies that we believe could withstand relatively low prices for a prolonged period, and we believe it takes careful analysis to identify attractive investments from the crowd.
Learn more about Invesco High Yield Fund.
1 Bloomberg, L.P. Feb. 17, 2015.
2 Barclays U.S. Corporate High Yield 2% Issuer Cap Index, Feb. 17, 2015.
Important information
The Invesco High Yield Fund seeks total return through growth of capital and current income.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
The Invesco High Yield Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality.
The Barclays U.S. Corporate High Yield 2% Issuer Cap Index is an unmanaged index that covers US corporate, fixed-rate, non-investment grade debt with at least one year to maturity and $150 million in par outstanding. Index weights for each issuer are capped at 2%. An investment cannot be made in an index.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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