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Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains. Since the energy dislocation began, an unprecedented amount of high yield energy bonds, especially those of shale fracturing E&P companies, have been trading in distressed/stressed territory. As shown in this week’s chart, the bars represent the par value of U.S. high yield energy bonds. The blue bars show the cross-section for May 2015, when $2.5 billion of bonds were priced at zero to 20 cents on the dollar, $2.1 billion were at 20 to 40 cents on the dollar, $7.0 billion were at 40 to 60 cents on the dollar and $19.9 billion were at 60 to 80 cents on the dollar. These values sum to $32 billion, or 15%, of bonds trading between zero and 80 cents on the dollar, which is known as distressed/stressed territory. Contrast this with June 2014, shown in the red bars, when only $0.8 billion, or less than 1%, were distressed/stressed. Clearly, this is an opportunity set that has emerged in the last twelve months and could pay off for investors.
There are two key channels through which investors can access this unprecedented opportunity. One is investing with an energy direct lender, which has two advantages. First, direct lenders can buy into a company’s debt at the top of the capital structure, above any existing bank loans and high yield bonds. This, in turn, gives the investor first-in-line access to the company’s assets in the event of a liquidation. Second, a direct lender can create further protection by negotiating heavy covenants, in contrast to the covenant-light bank loans and high yield bonds existing in the marketplace today.
The second approach is investing with a manager that specializes in buying distressed debt and working with the issuer through a restructuring to extract outsized value from the position. Because such managers would invest in existing covenant-light paper, it is beneficial to choose one that diversifies across oil and gas, coal, electric utilities, and alternative energy.
While distressed energy debt may not be appropriate for all institutional investors, it could also prove accretive to clients in the coming years. As we have seen many times in the past, buying at depressed prices often leads to outsized returns in subsequent years. Given the overall high valuations in the financial markets, we believe distressed energy offers a compelling valuation at this time and could help boost future portfolio returns.
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