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Energy bonds face ‘big default cycle’ warns asset manager

Renewable energy players could emerge more resilient from the shake up


Elena Johansson

The dramatic oil plunge last week could lead to a swathe of energy companies defaulting, an asset manager has said.

Mark Benbow, investment manager, fixed income at Kames Capital, told Expert Investor that there may be a “big default cycle coming” in the energy space later this year or early next year, “because of the very dramatic price action that happened with oil”.

Brent oil has entered into bear market territory, declining by 13.6% during the week of February 28 because of worries about the coronavirus, according to Refinitiv.

The sell-off intensified and brent oil declined by 24.1%, its largest one-day drop since 1991, after Opec+ failed to achieve cuts in oil production, Refinitiv said (see chart below).

Tajinder Dhillon, senior research analyst at Refinitiv, wrote in an article that oil majors, including ExxonMobil, Chevron, BP, Eni, and Total, have all seen downgrades.

When looking at the energy debt of the US high yield index (BAML US High Yield Index) it appears to be concentrated towards lower rated bonds; particularly in BB3, B1, CCC1, and CCC3 buckets, Dhillon noted.

Benbow believes that the oversupply of oil could trigger a downward spiral in oil prices.

He suggests that, if oil prices are cut by half, oil companies would react by doubling their production to balance out their tumbling revenues.

“That obviously floods the market with even more supply, which pushes the oil price down even further.

“So, it becomes this kind of self-fulfilling prophecy of downward-spiralling oil prices, unless you can get some sort of central agreement with Opec, which is obviously broken down,” he explained.

While oil companies are in a very tough position, renewable energy companies are equally affected by collapsing oil prices, Benbow remarked, as their revenue base is reliant on the same underlying commodity price.

The situation has become so dramatic that even short-dated bonds, which tend to be less volatile, have been selling off in energy, he added.

Strategies to counter volatility

Different types of strategies can help investors reduce volatility in turbulent markets.

Peter Schwab, high yield portfolio manager at Impax Asset Management, told Expert Investor that the only way to succeed in this environment is a short-term government bond-focused strategy.

Schwab also warns of wider impacts from vulnerable energy companies on the bond market.

“Any bond strategy that has meaningful corporate risk, including investment grade, is likely to be showing signs of stress. The large cohort of energy companies that are vulnerable to downgrades is putting pressure on both the investment grade corporate market as well as high yield,” he said.

Paul Cavalier, partner at Mercer, points to the advantages of benchmark-agnostic strategies in volatile markets.

“Active managers who follow this style of investing are able to be aggressively short, relative to the index, or avoid altogether sectors or issuers that are impacted by geo-political return drivers, which are hard to model,” Cavalier said.

In volatile markets, Kames’s Benbow highlights that investors can benefit from in-depth analysis of companies.

“Even if we have a default cycle in energy, the assets are still worth something to someone. The multiples on those assets might be lower than what they were a month ago, but they’re unlikely to be worth zero,” he said.

Unlike equity investors, bond holders don’t necessarily lose all their money if a company defaults.

“You can have your bonds fully covered by the assets,” Benbow explained.

“It depends how leveraged that businesses is in terms of how much equity sits within that business. What we’re effectively doing is we’re trying to find companies which have very strong recovery [potential].”

Impacts on the low-carbon transition

Some believe that a shake up in the energy sector could benefit renewable energy companies.

However, low oil prices could also have negative effects for the energy transition in the short term, others argue, as it could hurt demand for renewable energy.

Schwab explained to Expert Investor that low oil prices may stimulate oil demand in the short term and could put modest pressure on bonds issued by renewable energy companies.

However, he said, in the longer term, “alternative forms of renewable and clean energy will be more competitive than fossil fuels and ultimately displace them”, as the demand for fossil fuels will be too low to generate reasonable returns.

In order to provide investment opportunities, Schwab said, traditional fossil fuel energy companies would need to undergo “material changes in their business model” by allocating profits into clean energy production.

But Impax sees “very few traditional energy companies doing this with any real conviction and commitment now”, which is why the firm focuses on companies offering energy efficiency products.

Cavalier also alerts investors to the longer-term risks of the oil sector: “The recent oil price decline has seen many bonds by energy companies underperform the market.

“In the short term, these bonds might offer attractive yields, but over the longer term they might end up being ‘stranded assets’,” he said.

Energy transition

Kingsmill Bond, energy strategist at non-profit think tank Carbon Tracker, argues that investors should use the current shake-up as a value opportunity to build strong positions in renewable energy.

“Investors should resist the temptation to go back into the fossil fuel sector,” given that oil and renewable energy will see opposite structural demand.

Bond said “renewable energy supply is on an exponential growth curve”, and that growth “will come roaring back”, due to the sector’s falling costs and rising demand.

The oil sector, however, is facing an array of challenges, he added.

Profitability “has been propped by a cartel whose existence is threatened by the structural shift, and the sector now faces a future of massive overcapacity, rising taxation and falling demand”.

“There will be a shake-up in the sector now and the stronger players will emerge more resilient,” he said.