Energy Debt Investors Reap Gains On Oil Rise, But Risks Loom

The rebound in oil prices since mid-March is paying off for holders of corporate bonds of energy companies, and investors are confident that they will outperform Treasuries this year, despite lingering risks.

 

U.S. crude oil prices have rallied more than 32 percent to near their highest levels of the year, last trading at about $59.25 a barrel, after a more than 50 percent drop from June 2014 through mid-March.

 

The gains helped the Barclays (BCS) High Yield Energy Index rise 4 percent in April, its second-best month since 2011.

 

Even as crude oil has rebounded, investors say many credits in the energy sector remain cheap because of concerns about global demand. But more buyers might move into this area, particularly with government debt yields still low.

 

U.S.-based taxable bond funds had 2.8 percent of their assets invested in energy bonds as of March 31, up from 1.7 percent a year earlier, according to Morningstar (MORN).

 

"Treasuries are significantly overpriced in the current market while energy bonds are cheap," said Kevin Dachille, institutional portfolio manager at Eaton Vance.

 

Dachille said credits of offshore drillers were oversold. He owns high-yield issuers Pacific Rubiales and Pacific Drilling and investment-grade Rowan Companies PLC (RDC) in his $2 billion Eaton Vance Bond Fund.

 

Gains in energy debt would lift the high-yield market more since energy companies comprise about 16 percent of that market, according to data from research firm CreditSights. Energy makes up about 13 percent of the investment-grade market, the firm said.

 

High-yield energy bonds have gained more than 7 percent so far this year after last year's 8 percent loss, according to Barclays. Investment-grade energy bonds have gained 2 percent, after a 3.8 percent return for 2014.

 

Michael Wildstein, senior portfolio manager at Delaware Investments, said energy bonds should outperform as long as oil prices remain stable. He owns investment-grade credits Continental Resources (CLR) and Energy Transfer Partners , and high-yield issuers Newfield Exploration (NFX) and Chesapeake Energy (CHKVZ) in his $1.4 billion Delaware Corporate Bond Fund.

 

Last year's loss in high-yield energy bonds coincided with the bulk of the decline in U.S. crude prices, which dropped to a six-year low of $42 a barrel on March 18 from more than $107 a barrel last June.

 

Some segments of the sector remain at risk for default, particularly fracking companies. Two Texas-based energy companies, BPZ Resources Inc and Quicksilver Resources Inc, filed for bankruptcy protection in March.

 

"You still have to be concerned about credit defaults, particularly among those that have leveraged up their balance sheets," said James Swanson, chief investment strategist at MFS Investment Management in Boston.

 

Another risk is that corporate bonds broadly could fare worse than U.S. Treasuries if the Federal Reserve hikes interest rates this year.

 

"When the Fed does finally move, you could see a bigger selloff in the credit products than in the Treasury market," said Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC. He said a lack of liquidity among corporate bonds heightened that risk.