High-yield energy bonds are on track for their worst year since the global financial crisis yet some funds are holding on, convinced that markets underestimate the ability of many oil companies to ride out the crude price slump.
Some money managers such as Western Asset Management Co., Eaton Vance Corp. and Aberdeen Asset Management have broadly held on to their investments in bonds of oil and gas producers throughout the year even as now they lag more than 95 % of their peers, according to Morningstar data.
Their exposure to energy is around 10 % or more, with varying shares of that in high-yield energy debt.
The average yield on U.S. high-yield E&P credits has risen to 13.7 % through Friday from 10.6 % at the end of last year, according to Barclays PLC. That increase reflects fears that many companies will struggle with financing their operations and servicing their debt with oil stuck at around $45 a barrel, less than half of last year's highs.
The Barclays U.S. High Yield Energy Index is down 8.6 % so far this year through Friday, putting it on track for its worst yearly loss since 2008.
As of Sept. 30, 8.5 % of the $117 billion of outstanding high-yield debt issued by U.S. oil and gas firms was in default, either because they missed payments to bondholders, entered bankruptcy or conducted a distressed debt exchange according to Fitch Ratings, a record high since it began tracking the data in 2000.
With oil near its six-year lows, many investors expect those numbers to go up and avoid the sector altogether. Some, however, say the market is too pessimistic about oil prices and producers' resilience and maintain bets on selected energy bonds, even if it means being stuck in the red so far this year.
"Market pricing suggests almost one out of every two high-yield energy issuers will default," said Michael Buchanan, head of global credit at Western Asset Management Co., citing his firm's proprietary valuation model. "Anything less than that is a win for investors."
Investors have pulled about $270 million from Buchanan's Western Asset Short Duration High Income Fund this year according to Lipper data, part of a roughly $6 billion outflow from U.S.-based high-yield mutual funds. Buchanan's fund had $840 million in assets at the end of last month.
PICKING THE SURVIVORS
Yet unlike many oil executives and Wall Street analysts who brace themselves for a "low for longer" scenario, Buchanan expects cheap oil to force production cuts and help prices recover to between $60 and $70 a barrel over the next year or two.
He also said his fund had invested in energy firms that had access to credit and ample cash relative to their spending, posing a low risk of default even if oil prices remain low.
Kathleen Gaffney, who has managed the Eaton Vance Bond Fund since its launch in January 2013, said she also focuses on the likely high-yield survivors. Such bets could produce gains of more than 30 % over the next two years, she said. Among the $1.2 billion fund's assets is a 1 % investment in convertible bonds in Chesapeake Energy Corp.
"There will be survivors, and I think Chesapeake is one of them," Gaffney said.
Patrick Maldari, senior fixed income investment specialist at Aberdeen Asset Management, said his team running the $1.3 billion Aberdeen Global High Income Fund favored companies with access to revolving credit facilities as a feature that improved their odds of riding out the slump.
Some funds betting on high-yield energy bonds still managed to eke out gains. The $74.6 million Morgan Stanley Institutional Fund Trust High Yield Portfolio, which counted Baytex Energy Corp. and Carrizo Oil & Gas among its credits as of Sept. 30 is up 2.9 % so far this year beating 96 % of peers, according to Morningstar.
Its winning formula?
Richard Lindquist, who oversees the fund, says it focuses on higher-quality credits that have hedged future production and operate in low-cost areas such as the Permian, Eagle Ford and Marcellus basins.
Even those in the red like Gaffney, whose fund is down 10 % so far this year, are not giving up, saying many investors are too pessimistic about global growth and prospects of some companies.
"The whole sector has been painted with a very broad brush."