The Impact of Energy Prices on High-Yield Bond Funds
Positioning within the high-yield energy sector will differentiate managers in 2015.
In the years coming out of the credit crisis, high-yield bonds were hard to beat. As global credit markets recovered and the U.S. economy enjoyed a period of steady, if moderate, growth, the high-yield Morningstar Category earned an annualized 16% return between 2009 and 2013. Default rates fell sharply after 2009 and remained low; with the exception of a brief stretch in 2011, funds that took the most credit risk ranked among the category's top performers. Many expected more of the same in 2014 with managers citing relatively solid credit metrics and a generally supportive economic environment. However, 2014 had a surprise in store. Energy prices started to tumble in July and had fallen about 50% from their June peak by the end of the year.
Few asset classes have been as directly affected by the energy market as high-yield bonds. High-yield bond funds returned a paltry 1.1% on average in 2014, the category's worst year since 2008, thanks to a rough second half. As shown in the table below, most high-yield bond funds declined in the second half of 2014, wiping out gains from the earlier part of the year. Interestingly, while BB rated bonds generally held up better than lower-quality fare in 2014--not surprising given that these bonds have stronger credit metrics and are also more sensitive to changes in broad market bond yields, which fell during the year--there was a wide dispersion of returns by sector, with energy sharply lagging the rest of the market. The category declined 3.6% during the last six months of 2014, with a 13% decline in the high-yield energy sector driving losses.
The Energy Tail Wagging the High-Yield Dog
Energy companies borrowed heavily following 2008's financial crisis, taking advantage of new drilling opportunities, high oil prices, and low interest rates. According to data from J.P. Morgan, more than $1.9 trillion of new high-yield bond issuance occurred between 2008 and 2014. Of this, just more than 15%, or $290 billion, was issued by companies in the energy sector. As a result, the high-yield energy sector grew from 10% of the Bank of America Merrill Lynch High Yield Master II Index at the end of 2007 to near 15% at its peak in 2014. In comparison, the energy sector made up 8.4% of the S&P 500 as of Dec. 31, 2014.
Not surprisingly, for junk-bond funds, performance in 2014 largely came down to the size and makeup of a fund's energy weighting. Across the 22 U.S.-domiciled open-end high-yield bond funds rated by Morningstar Manager Research analysts, many of the top performers for all of 2014 and the second half of the year benefited from a combination of an underweighting in the energy sector relative to the market and strong security selection within the sector. As shown in the table below, funds that performed relatively poorly last year were mostly affected by overweightings in energy-related holdings.
A few funds stand out for their strong relative performance in the second half. Several historically more conservative funds did particularly well. Vanguard High-Yield Corporate (VWEHX), which has a Morningstar Analyst Rating of Bronze, returned 4.5% for the full year and lost only 0.40% during the second half of 2014, easily outperforming the category during both those periods. The fund benefited from its focus on the higher-quality end of the bond market but also from manager Michael Hong's decision to have an underweighting in energy names, which was driven both by his bearish outlook on natural gas prices and his concerns about the need for ongoing and significant capital expenditures. The story was similar for PIMCO High Yield (PHIYX), another relatively high-quality fund, which also dedicated just 10% of its portfolio to energy-related names.
Several funds that fall closer to the middle or more-aggressive end of the high-yield fund universe also navigated 2014's waters skillfully. The team that runs Lord Abbett Bond-Debenture (LBNDX) and Lord Abbett High Yield (LHYAX), for example, has historically favored energy but moved to a slight underweighting during 2014. The team pointed to aggressive company-specific financings and the overall increased issuance of high-yield bonds by energy firms as a warning sign that the sector was overheating. The portfolio focused its energy stake on higher-quality producers based primarily in the Permian Basin. The fund began lowering its exposure to both oil service and exploration and production, or E&P, credits during August and September of 2014. Meanwhile, the fund was overweight in sectors that it viewed as likely to benefit from declining oil prices, including the consumer goods, retail, and leisure industries. Fred Hoff, the manager of Fidelity High Income (SPHIX), has historically treaded carefully in the energy sector, arguing that the combination of commodity risk and leverage makes for a potent mix. Hoff's returns were held back by positions in Samson Resources, but the fund's overall underweighting and avoidance of sizable benchmark components like SandRidge Energy (SD), Halcon Resources (HK), and Midstates Petroleum (MPO) helped the fund outperform some of its peers. Meanwhile, Fidelity Capital & Income (FAGIX), one of the category's most aggressive offerings, benefited from an energy underweighting and strong performance in its large equity stake, which approached 20% at year-end.
Given the growth of energy as a component of the high-yield market, many funds held sizable positions within the sector. As energy firms were the largest issuers of high-yield debt in recent years, it was relatively easy for portfolio managers to put inflows to work by purchasing new-issue energy bonds. Many managers also considered energy as a relatively conservative play within high yield because of the asset-rich nature of these firms' balance sheets.
Funds with higher energy exposure included Janus High-Yield (JHYFX) and Metropolitan West High Yield Bond (MWHIX). Janus High-Yield fell 4.6% during the back half of 2014 and squeaked out a gain of 0.70% for the full year. The fund held a 17% stake in energy bonds at the end of 2014, and the fund's E&P holdings, including Samson Resources, Templar Energy, and SandRidge, drove most of the fund's poor returns. The MetWest fund held a 20%-plus stake in the energy sector throughout last year, and its returns suffered accordingly, returning 0.33% for 2014 and declining 3.7% during the last six months. The fund's positions in hard-hit E&P names like Chesapeake Energy (CHK), Newfield Exploration (NFX), and SandRidge drove much of the decline. Coal-mining firms were also hit hard in 2014, and the fund held positions in Walter Energy (WLT) and Arch Coal (ACI) that also detracted from returns. Hotchkis & Wiley High Yield (HWHIX) maintained a neutral position in energy relative to the market, but its focus on smaller companies hurt results. Western Asset High Yield (WAHYX) and Franklin High Income (FHAIX) had two of the poorest returns across high-yield funds during the second half of 2014. Western remains bullish on names like Sanchez Energy (SN), and Franklin has also been holding and even adding to its energy stake, which was already near 25% at the end of 2014. Fairholme Focused Income (FOCIX) is a concentrated portfolio with only 10 individual positions across many sectors, and many of the fund's holdings performed poorly in 2014. The fund's primary energy exposure comes from a 2.6% position in preferred stock of Chesapeake Energy.
Morningstar analysts are paying close attention to the approach that portfolio managers take toward the high-yield energy market, and that can have an impact on a fund's Process Pillar rating. While we do not maintain a house view on the direction of oil prices, we do expect investment teams to be thoughtful and realistic about oil prices. Even if long-term expectations call for higher prices, investors should be careful not to anchor on historical prices. Investments in the sector should, at a minimum, include realistic base-case scenarios that assume oil prices stay below $50 per barrel.
Positioning within the energy sector was the primary driver of performance in 2014 and will continue to differentiate high-yield bond managers in 2015. With an increase in distressed names within the sector and/or the probability of a pickup in defaults, this will also provide managers with a visible opportunity to prove their credit-picking chops.
Sumit Desai, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.