Energy Bonds Sweet Spot: The Might Be Good

With oil prices falling sharply again this week, energy credits have come under major pressure. Here are some views on the current landscape and some thoughts on where there could be opportunities. I think of these bonds as falling into three categories: the bad, the ugly, and the might be good. The Bad Over the last several years, as emerging markets demand for commodities soared and the U.S. shale boom fueled energy infrastructure spending, there has been heavy debt issuance by energy companies. Not surprisingly, when the price of the underlying commodity drops by 50%, it puts many companies in distress. I don't think it is a stretch to say that few of these bonds were underwritten with bond buyers assuming that WTI crude would be below $40. Bond prices can fall quickly when default becomes a legitimate possibility. Distressed feeds on itself. Take Chesapeake Energy (CHK). This is a company with several large bond maturities coming in 2016 and 2017. If it can't roll that debt over, if the bond market isn't open to continuing to fund them, then bankruptcy is highly likely. The company's 4.875% bonds maturing in 2022 were trading above $95 (in bond speak, that means 95 cents on the dollar) as recently as June. They were trading above $80 as recently as mid-October. It is now trading around $27. Anyone looking to buy these kinds of bonds has to do two pieces of analysis. First, you need to determine if the company can survive on a cash flow basis. Exploration and production is a very capital-intensive business that eats up a lot of cash even in good times. At $40 oil, the cash bleed is severe in many cases. Equally importantly, you need to guess whether the company will have access to the debt markets. Right this minute both the bank loan and the high-yield bond market are shut off to E&P companies. Some companies may be able to entice a lender by pledging certain assets that are not already encumbered, but if that happens it actually drains value away from existing bond holders. So unless access to capital changes, these companies are ships adrift, just waiting to hit rocks. The Ugly So if you can't buy distress in energy, can you buy high quality? I argue that much of the investment-grade energy market is the ugly. I'm referring to high-quality names such as EOG Resources (EOG), Anadarko Petroleum (APC), Apache (APA), ConocoPhillips (COP), etc. These names are probably fine and could certainly access the market anytime they wanted to. But they are all trading with yield spreads (the difference in yield between the bond and a corresponding Treasury) of 200 basis points or less. What's the upside? For a 5-7 year type bond, you are looking at a yield in the 3.75% area with minimal chance of capital appreciation due to spread tightening. But what's the downside? Look no further than Kinder Morgan (KMI), whose bonds traded as low as $80 last week before rebounding a little to $84 today. There are many bond buyers who can get a little complacent. These are often buyers who don't trade much (such as insurance companies who rarely sell positions) and thus tend not to think much about mark-to-market risk. But these same buyers become panicky when there is a whiff of trouble. With today's liquidity environment, names that seem like high quality one day can find themselves down 10 points on a bad quarter. The upside potential doesn't justify the downside risk. The Might Be Good I want to own bonds with a little bit of trouble priced in, but of companies with balance sheets that will almost certainly given them solid access to capital. Such companies can survive a few years of weak oil but have enough spread to have good upside should oil rebound even a little. In other words, these are companies that can survive with oil hanging around where it is, so I don't need an immediate catalyst to avoid a serious downside case. Because the bond has some trouble priced in, I'm getting paid enough yield now that just holding the bonds is attractive. And I have extra upside if oil bottoms soon. Right now I'm holding Energy Transfer Partners (ETP) and Noble Energy (NBL). You need to do your homework on these bonds. Know where you are in the capital structure, what assets you can claim, what ability the company has to pledge assets away from you, etc. Beyond these two, we are working on a few more. I think this is a time to nibble on energy bonds of this type. As for distressed stuff, I'll pass. And as for the ultra-high quality, I'll wait for them to slip up a bit and fall into the Might be Good category.

Energy Bonds Sweet Spot: The Might Be Good

I think of these bonds as falling into 3 categories: the bad, the ugly, and the might be good.

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