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
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.
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.
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.