Risk aversion and rising dispersion has created valuation discrepancies within certain segments of the high yield market. Despite our cautiously optimistic outlook based on relatively stable credit fundamentals, relatively benign default expectations and supportive technicals, environments like this expose hotspots of idiosyncratic risks and potential opportunities. While we anticipate energy sector volatility to remain high, with good credit selection we believe the energy sector could be a performance differentiator in 2020.
Energy: Is it really that bad?
In 2019, the high yield energy sector dramatically underperformed the broader high yield market. This was somewhat surprising given the underlying WTI spot crude market posted a positive year-to-date return over 25% through December 31 (Exhibit 1).
Exhibit 1: WTI Spot Crude vs. High Yield Energy Index Returns
Source: Bloomberg, Barclays Live as of December 31, 2019. Reflects price change or total return since December 2018 indexed to zero.
- We believe the reasons for underperformance include:
- Investor concerns around many high yield issuers' ability to generate long-term returns in a $50-60 crude environment.
- Investors' frustrations with continued high levels of capex by most issuers.
- Weakness in the natural gas market.
- An increase in energy-related defaults and upcoming debt maturities, leading to heightened concerns around distressed exchanges and priming.
- Investor concerns related to carbon emissions and the sector's long term viability
As we moved throughout 2019, we witnessed significant selling and lack of investor interest, causing valuations to cheapen. Late in the year, as a risk-on tone permeated throughout the high yield market, we saw much of the sector rally significantly, driven by a reversal in the some of the negative trends noted above, OPEC production discipline and oil price volatility driven by geo-political risks. As we look out to the rest of 2020, we believe the sector remains interesting based on the following:
Fundamentals: While the market has been focused on the aforementioned negatives, we don't think it's as bad as it appears. In the current range-bound crude market, many of the higher-quality and mid-tier companies have the potential to generate reasonable returns. It also seems that capex has peaked, and is coming down as management teams focus on spending within their cash flows. In addition, we expect M&A activity will continue as companies look to eliminate duplicative costs and focus on improving margins.
Valuations: After the significant underperformance in 2019, the high yield energy sector is trading materially wider than the rest of market. Within the Bloomberg Barclays US Corporate High Yield index, the energy sector has a yield to worst of 9.14% compared to 4.91% for the index excluding energy as of December 10. In a market with limited convexity, this is one sector that has the potential to deliver strong positive returns.
Technicals: While energy remains a large sector within high yield, it seems many dedicated high yield investors are underinvested relative to benchmarks. Therefore, while the market has suffered due to significant selling in 2019, we think the worst of the negative technicals may be behind us. The energy sector has the potential to attract interest from new buyers given the attractive valuations and balanced fundamentals. Of note, since the first of the year, unsecured debt markets have begun to reopen to certain BB and B issuers needing to refinance debt. This provides opportunities to selectively add exposure where we feel where risk/return looks attractive.
Sentiment: Negative sentiment around energy companies, both in fixed income and equity markets, was as pessimistic as the tone during the energy crisis in 2015. This negative sentiment has begun to turn the corner and become more positive, which we expect will continue.
All that considered, we are more constructive on the high yield energy market than we have been in many years. This leads us to believe that energy could be a differentiating sector for performance in 2020.
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