a subsidiary of Purpose Investment Inc.

Energy bonds - A sign of things to come in high yield?

The decline in energy prices has been felt by many Canadians.  Even those investors with limited exposure to energy companies have seen their account values decline in recent weeks.

With OPEC deciding not to cut their production, it is clear that investors are reacting to supply dynamics, versus broader concerns about economic growth and the demand side of the energy equation.

That said, with credit spreads and interest rates near record lows, there is increasing concern that lower energy prices will force marginal energy producers – many of whom have levered up their projects with low priced debt – will suffer if lower energy prices prevail.

A number of articles from major publications in recent days, are quite alarming.

Does the oil price collapse put the high yield market at risk? Forbes

Oil price slide leaves investors facing zero returns – FT

Falling Oil Prices Could Lead to Massive Junk Bond Defaults – WSJ

The Fed’s Quantitative Easing program and its downward impact on interest rates has had a far reaching impact on many areas of the economy.  In October, Redwood portfolio manager Richard Bernstein of Richard Bernstein Advisors pointed out that low interest rates have benefited many marginal energy projects.  Watch the video here.

“The Fed lowered the cost of capital to make all these energy projects profitable.” Bernstein

A major theme for the year ahead, will be the impact that the yield curve and the potential rise in rates will have on the cost of capital of companies raising funds. It is unclear whether energy will be the impetus for a broader re-rating in high yield, but a higher cost of capital is coming, and will squeeze companies on the margin.

Some interesting facts:

  • The ‘marginal’ energy projects that many people are speaking of, are US shale projects.
  • Shale have high decline rates and are typically only profitable over $65 a barrel
  • Energy companies are the largest part of the high yield bond sector.
  • Yields on high yield energy started the year at 5.76% and currently sit at 7.31%
  • JPM expects that up to 40% of energy companies could default should the oil price stay below $65 for  three years (20-25% if it stays at $65)
  • Energy makes of 28% of the distressed high yield market.

Beware and be aware.

PJS

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