High-yield bonds are having a terrible year so far. That’s bad news for these bondholders, but good news for financial advisors and clients considering buying into this landscape of troubled debt.
Not surprising, the heart of the problem is energy companies’ debt, which oil companies loaded up on when issuing during the drilling boom that predicted that oil might rise to US$200 a barrel. Some current investors are selling; canny advisors and their clients may find bargains.
Oil has traded lately at around US$30 a barrel for the good stuff – light sweet crude – and even less for heavy Canadian crude. Yields on long-term bonds issued by top producers such as Cenovus Inc. and Encana Corp. have been priced at almost double-digit levels.
The consequence for issuers without an investment-grade A or B+ quality sticker is grave. And what hurts oil industry debt has been taken by the market as a generic problem for all subinvestment-grade debt.
New York-based Standard & Poor’s Financial Services LLC recently warned that 50% of all energy-related high-yield debt is in the distressed C-level category. Most of the junk bond market is U.S. debt. About US$180 billion of that is distressed, the highest level since 2012.
The genesis of much of the crisis goes back to central banks that wrenched down interest rates. With oil prices soaring and interest costs tumbling, oil industry issuers added massively to their debt.
Today, many junior companies in the energy and mining sectors can’t pay their debt and, as a result, defaults are rising.
For the brave, there is a lot of low-hanging fruit. For example, Toronto-based nickel miner Sherritt International Corp.’s 8.0% bond, due Nov. 15, 2017, has recently been priced at $49 to yield 57.35% to maturity. This bond issue has a B (“highly speculative”) rating from Toronto-based DBRS Ltd.
U.S. bond defaults rose to 106 in 2015, but the number varies slightly depending on the state of workout negotiations. One-third of the defaults were in oil and gas.
This past January alone, the U.S. high-yield market, where most subinvestment-grade debt trades, was down by 2% for the month. Returns in the sector were minus 7.6% in U.S. dollars, according to the Bank of America Merrill Lynch master II high-yield index. Currently, the index offers a yield of 9.23%, well above the 4.75% range experienced when markets are robust and the economy is growing strongly.
Lack of new supply
In the depths of the Great Recession of 2008-09, when junk was at a multi-decade low, the index’s yield was at 24%.
High-yield offers abound. For example, bonds from Toronto-based garbage collector GFL Environment Inc., with 7.5% interest, due June 18, 2018, have recently been priced at $98 to yield 8.44% to maturity – 806 basis points (bps) over Government of Canada bonds of similar term. Rated B by DBRS, these GFL bonds are nevertheless a reasonable buy, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto: “For two and a half years to maturity, they are OK.”
Jong adds that “GFL issued more debt in the last week of January and the issue was oversubscribed.” However, the issue was a rare offering these days.
“No company is going to issue debt into the high-yield space if it thinks the offering might not be sold out,” Jong says. “As a result, there is lack of new supply. Many fund [portfolio] managers and advisors are on the sidelines with a lot of cash. Thus, buy/sell spreads have widened to as much as 2%. Good high-yield names are hard to find and troubled names are available but not trading.”
“We see the market as cheap,” says Barry Allan, president and CEO of Toronto-based Marret Asset Management Inc.“The spread on high-yield debt averages 778 bps over government bonds of similar duration. The average is never over 800 bps without a recession.
“So, you can say that either we are going into a recession or that high-yield prices are now [in] a special situation because of energy and mining and minerals being so distressed,” he adds. “If there is no recession, then the broad high-yield sector’s offerings will be profitable.”
Allan’s advice: remove mining, metals and energy from the high-yield market’s figures and the spread over government bonds of similar duration is just 600 bps. You’d also have to take out some retail industry bonds because of the success of Seattle-based Amazon.com Inc. in gobbling up other companies’ sales, he adds.
As an example, the bonds of New York-based clothier J. Crew Group Inc. bonds are down by 70% from where they were at the start of 2015.
The question now is whether to flee from high yield or buy into bargains. According to Adam Smalley, senior fixed- income portfolio manager with Stanton Asset Management Inc. in Montreal: “There are a lot of opportunities in high-yield now, but most are outside of the energy space. And they are hard to trade.”
Moreover, Smalley says, there is fear that so many investors will drop out of junk bonds that the market will not be able to refinance high-yield bonds when they come due.
Ratings of B- and lower imply that one-third of all companies in the energy sector will default, Smalley says, adding: “Outside of energy, the default rate will be 2%.”
The knack is in spotting underpriced survivors.
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