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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Is This The Time To Buy Energy Bonds?

With the election of Donald Trump as President, the bond market is seeing a tremendous amount of turmoil among high quality issues. Interest rates on the long end have risen substantially as investors anticipate faster economic growth and higher inflation. All of this has led investors to shift out of bonds and into equities at a rapid pace. Energy investors following suit might be making a mistake.

Energy bonds these days are often short term debt with only a few years until maturity and relatively high interest rates. The debt for many energy companies is often sub-investment grade as well. Energy investors are making a mistake by giving up on such debt too easily.

While it is true that a rapid rise in interest rates would hurt the value of all existing bonds, energy bonds are probably better insulated than most. For one thing, by issuing short term debt the bonds have limited exposure to duration risk (i.e. interest rate risk).

More importantly, interest rates are not going to stay elevated unless the economy picks up steam, and if the economy picks up steam then oil prices will rise as well. Oil prices have been low as much because of lackluster demand as because of excess supply, and a stronger economy will help cure that demand shortage. And of course if oil prices pick up, then that will boost the financial stability of all but the weakest of energy companies which in turn should help lift bond prices.

The conclusion one might draw then is that investors in energy debt are in a no-lose situation. If the economy stays weak, any rise in interest rates or inflation will be temporary and limited. As a result, while bonds might lose a bit of value in the short term, in the medium term they should bounce back nicely.

Some investors may be concerned about inflation, but that’s mostly a red herring. Inflation is directly correlated to economic growth at low levels – that is weak growth is correlated with weak inflation and strong growth is correlated with strong inflation. This breaks down at higher levels of inflation – such as what Venezuela or Iran has seen lately – but that’s not a situation that’s relevant to the US or the developed world.

If the economy really does start growing faster under Trump, then energy companies will be direct beneficiaries. The industry is one of the few with excess capacity, and many oil companies would fare dramatically better over the next few years if the broader economy were growing at 3% instead of 1.5%.

To capitalize on opportunities in this space, investors should consider some of the bond ETFs that are available. Aggregated bond ETFs can offer investors attractive yields based on the level of risk one is willing to take. The data from Barclays below illustrates this.

(Click to enlarge)

Source: Barclays, S&P 9/30/2016

For those who are confident of an improving economy and rising rates, one interesting opportunity in the fixed income space at this point is in floating rate notes. Floating rate notes for the energy sector are not all that common, but there are a few. Floating rate senior bank loans in the energy sector for instance can be accessed indirectly through various bank loan ETFs like those from Powershares and Blackrock.

These floating rate energy sector bank loans will get a double boost from a successful Trump Presidency. Higher interest rates will lead to higher levels of income and a stronger economy will make energy companies able to afford higher levels of interest.

The converse of course is that if the economy fails to strengthen as expected, floating rate notes will lose value due to interest rates falling back, and energy companies will be left with a weak demand environment. For now, floating rate notes look very compelling though as their rates are often based on LIBOR which has been rising consistently in recent months.

Energy investors have a lot to be thankful for this Thanksgiving, but they also have a lot to consider about asset allocation going forward. With the end of the year upon us, this is the time to harvest taxable gains and losses, so the allocation question is a conversation smart investors should start having now.

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