Energy bonds: Unloved, out of favor, and potentially attractive

Energy bonds: Unloved, out of favor, and potentially attractive

Investments

Energy
equities and credit underperformed the broader markets in 2019, and within
energy credit, high yield bonds underperformed investment grade bonds. At
Invesco Fixed Income, we believe these performance discrepancies may create
interesting investment opportunities in 2020. In investment grade, we favor
midstream companies focused on corporate actions to improve credit
fundamentals. In high yield, we favor exploration and development companies
with positive free cash flow and midstream energy companies with diversified
assets.

2019 marked by
energy volatility

Looking back to a little over a year ago, the fourth quarter of 2018 was challenging for many asset classes as global recession fears mounted. Crude oil was particularly under pressure with benchmark prices down nearly 40% due to global demand concerns and a relentless rise in US shale oil production.1 But OPEC and key non-OPEC producers came to the rescue in December 2018 with the announcement of a coordinated production cut.2 Helped by easing global recession fears, oil rallied in the first few months of 2019 and has had the continued implicit support of OPEC and non-OPEC producers.

Fast
forward to the end of last
year, December 2019, and OPEC surprised the market again with an even
deeper production cut to stay ahead of a potentially over-supplied oil market in 2020.3 While oil has remained
partially supported by this ongoing supply-side management, natural gas prices have
been under pressure from surging US shale gas production, which has oversupplied the US market with little relief
in sight.

Decoupling of major energy markets

Against this backdrop
of commodity volatility, energy equities
lacked investor support in 2019 and largely underperformed the rest of the market.4
In credit markets, investment grade (IG)
energy outperformed high
yield (HY) energy.5 We believe
such performance discrepancies may create unique
opportunities for bond investors in 2020.

Figure 1: 2019 indexed asset class performance review

Source: Bloomberg L.P., Barclays Live, data from Dec. 31, 2018, to Dec. 31, 2019. WTI stands for West Texas Intermediate oil prices. OAS stands for option-adjusted spread. Note: US IG and US HY energy OAS index performance reflect inverse indexed changes for ease of comparison to other prices since bond yields and prices move in opposite directions. Indices are Russell 1000 Energy Index, Bloomberg Barclays U.S. Investment Grade Energy Index, Bloomberg Barclays U.S. High Yield Energy Index. Oil (WTI) and natural gas are prices.

In IG credit, midstream sector stands out

IG energy posted
positive returns in 2019 but underperformed the overall IG market.6 However, all
“energy companies” are not created equal, and we believe there is more credit
support embedded in the volume-driven midstream sector (companies that
transport hydrocarbons via pipelines) versus the commodity price-sensitive
exploration and production (E&P) sector.

While we wait to see
evidence of the E&P sector’s ability to consistently generate free cash, we
are more encouraged by the corporate actions taken and positive fundamental changes in the IG midstream sector.
Midstream companies have generally committed
to solid investment
grade ratings, slower growth, greater cash retention and reduced
leverage, resulting in select ratings upgrades. Midstream’s search for a lower cost of capital has also included
asset sales, dividend cuts, de-levering mergers and acquisitions, corporate simplifications
and joint ventures, among other bondholder-friendly actions.

We expect more credit-supportive corporate
actions in 2020. Further, attractive relative valuations,
in our view, compared to the IG index (after 2019’s relative underperformance) and the sector’s focus on slower
growth, greater cash retention and lower leverage could bode positively for
bondholders in 2020.6 We expect the midstream sector to remain
focused on cost of capital
optimization in a way that is accretive, not only to the equity community, but also to bondholders.

Brighter macro outlook
could boost HY energy in 2020

Within HY, the
energy sector was by far the worst performing sector in 2019.7 However, most
of HY energy’s underperformance was due to CCC
energy names and, to a lesser extent,
single Bs.8 BB energy names performed more in-line with the overall market.9

There
are several reasons that HY energy underperformed last year:

  • A greater number
    of energy bankruptcies with low creditor recoveries.
  • Investor fatigue due
    to volatility in recent years.
  • Uncertainty over oil and gas prices due to macro and supply concerns.
  • Poor energy equity performance as investors pushed back on the
    industry’s historical focus on quick growth over profits and cash flow.
  • The perception that HY’s access to capital was largely closed (except
    to high-quality BB-rated
    energy companies), impairing the extension of looming bond maturities in 2021 and 2022.
  • The outsized natural gas exposure of
    some HY issuers.
  • Poor technicals, as HY was out of favor with money managers
    and some credit hedge funds.

If the macro picture
improves, or even stabilizes, 2020 could see a reversal of 2019’s poor technicals, and HY energy could gain
positive momentum as the perceived access
to capital improves, allowing some stressed issuers to potentially refinance and push out near-term maturities.

Given this
possibility, and our view that spreads and yields have reached attractive levels in an otherwise tight market, there may
be compelling opportunities in US high yield energy in 2020. In this space, we favor
E&P companies that are rated single
B or BB, have low production costs, are expected to generate positive
free cash flow,
and have manageable bond maturities. We
also favor midstream companies with diversified assets
and minimal exposure
to basins that are
expected to experience lower volumes,
especially in natural gas.

Conclusion

After
uneven performance in 2019 across commodities, energy credit and energy
equities, and given broader economic uncertainty, investing in US energy credit requires caution, in
our view. The potential for continued commodity and bond price
volatility warrants a vigilant and deliberate investment approach.

At Invesco Fixed
Income, we believe this backdrop may create
investment opportunities for meticulous and value-oriented active investment managers. As such, we continue to scour the universe of IG
and HY energy credit for opportunities exhibiting creditor-specific catalysts and
attractive risk-adjusted return
potential.

1 Source: Bloomberg L.P., Reflects the 38.0% price change for oil (WTI) from Sept. 28, 2018 ($73.25 per barrel) to Dec. 31, 2018 ($45.41 per barrel).

2 Source: OPEC, Dec.
7, 2018.

3 Source: OPEC,
Dec. 6, 2019.

4 Based on index
price changes for the period
Dec. 31, 2018, to Dec. 31, 2019, for the Russell
1000 Energy Index
(+6.7%) vs. the Russell
1000 Index (+31.4%).

5 Based on changes in the index OAS from Dec. 31,
2018 to Dec. 31, 2019  for the US Investment Grade Energy Credit
Index (31.8% OAS decline) vs. the US High Yield
Energy Credit Index
(9.0% OAS decline). Spread
declines imply price improvements.

6 Based on
changes in the index OAS from Dec. 31, 2018, to Dec. 31, 2019, for the US Investment Grade
Credit Index (37.2% OAS decline) vs. the US Investment Grade Energy Credit
Index (31.8% OAS decline).
Spread declines imply price improvements.

 7 Based on 4.71% total returns
for the J.P. Morgan Domestic
High Yield Energy
Index versus 14.08%
total returns for the J.P. Morgan
High Yield Index,
data from Jan. 1, 2019, to Dec. 12, 2019.

8 Source: JP Morgan,
“Credit Market Dysfunction: A Story in (Mostly) Pictures,” Tarek Hamid,
Jon H Dorfman, CFA, Aaron
Rosenthal, CFA, Nov. 1, 2019.

Source: JP Morgan estimates, data
from Jan. 2, 2019, to Dec. 31, 2019.

9
Ratings source: Standard & Poor’s. 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. Not Rated indicates the debtor
was not rated and should not be interpreted as indicating low quality. A
negative in Cash indicates fund activity that has accrued or is pending
settlement. For more information on Standard and Poor’s rating methodology,
please visit www.standardandpoors.com
and select ‘Understanding Ratings’ under Rating Resources on the homepage.

Important
Information

Blog header image: Jose Luis Stephens / EyeEm / Getty

The OAS or “option-adjusted spread” is the
difference between the yield of a fixed income security and the risk-free
yield, which is adjusted to take into account an embedded option. Typically, a
US Treasury yield is considered the risk-free rate.

The Russell 1000® Energy Index, a trademark/service mark of the Frank Russell Co.®, is composed of energy-related securities.

The Bloomberg Barclays US
Corporate High Yield Energy Index includes high yield rated debt issues from
North American companies involved in the energy sector.

The Bloomberg Barclays US IG Energy Index is a sub-index of the Bloomberg Barclays US Credit Index, which measures the investment grade, US dollar-denominated, fixed rate, taxable corporate and government related bond markets.

Past performance cannot guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of loss.

A value style of investing is subject to the
risk that the valuations never improve or that the returns will trail other
styles of investing or the overall stock markets.

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.

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 opinions referenced above are those of the author as of Feb. 5, 2020.
These comments should not be construed as recommendations, but as an
illustration of broader themes. Forward-looking statements are not guarantees
of future results. They involve risks, uncertainties and assumptions; there can
be no assurance that actual results will not differ materially from expectations.

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