Does Your Retirement Need This “Essential” High-Yield Bond?

Steve McDonald By Steve McDonald, Bond Strategist, The Oxford Club

Bond Investing

Essential industries are a great place to invest during your retirement and while you’re building your nest egg.

Nothing is more essential than energy. We’re dead in the water without it.

Energy is as important to our survival as food and shelter. That alone makes it a great place for retirement investing.

The fact of the matter is, it’s an industry that isn’t going anywhere.

But in energy bonds, you have to look way beyond just the yield. Unlike any other sector, the fundamental indicators in energy don’t necessarily produce the results most investors have come to expect.

That’s why it’s an essential unlike any other…

Going “Wild” for Income

The oil and gas industry – especially the guys who go out and find the stuff in the ground – have a rough reputation.

These are no nonsense, push it to the limit and work like crazy folks. They come home dirty and smelly. They make no apologies for their appearance. But most importantly, they’re known for delivering the goods.

When you look at the balance sheets of many of these wildcat companies, they look just as wild and rough. Energy exploration and development is a very expensive game, and it’s all about leverage, or borrowing the money to do it.

So, the balance sheets of many of these companies – when compared to other industries – are often far from pristine.

But as you’ll see, in this sector, the numbers don’t seem to mean that much.

Take a look at Comstock Resources (NYSE: CRK).

This is an exploration and drilling company that has a market cap of just under a billion dollars. That might not sound like much, but for the small independents of the oil and gas industry, that’s above average.

But Comstock’s profit margin is an uninspiring -9.6%… That means it’s losing money… At least for now.

It produces roughly $450 million in revenue annually. But it shows no real year-over-year revenue growth. The ridiculously low price of natural gas has really crunched its whole business.

But here’s the real killer…

Comstock only has a measly $18.7 million in cash, but has $1.22 billion – yes, billion – in debt. Ouch!

To just about everyone this looks like a disaster waiting to happen.

Its balance sheet has lots of debt, a terrible profit margin, virtually no revenue growth and the market price for its product is still in the toilet…

But here’s the amazing part about fundamentals for gas and oil companies: Comstock’s stock price is just below its 52-week high. And its shares are up more than 16% this year.

Even more surprising, Comstock’s bonds are selling at a premium. That means they’re actually priced over par.

That tells us somebody is looking at something other than their balance sheet.

Because based solely on the company’s numbers, this is nuts!

High Yields on Low-Priced Natural Gas

Comstock has a bond with a coupon of 8.375% that matures on October 15, 2017.

Right now, that bond’s selling for about 104, or $1,040. That’s $40 more than you’ll get back in principal at maturity.

Look at a company in almost any sector that’s losing money, shackled with a ton of debt and almost no cash, and I guarantee you its bonds won’t be priced like this one.

The bond’s average annual return is about 5.7%, which isn’t bad when you consider what CDs and money markets are paying. But it’s insane when you consider that the company – on paper – looks like a total train wreck.

In any other sector this bond would be selling at a discount!

Now consider Chesapeake Energy (NYSE: CHK).

I know it’s had a really bad year. Its CEO looks like he may be a crook, but he did build one of the best energy companies in the world. The company is selling off assets to offset the fact that they spent way too much on gas rights. Nothing smells right about them…

But from a bond perspective, they’re golden.

Unlike most of the gas business, Chesapeake is making money! An 18% profit is nothing to sneeze at in the energy sector.

It has $1 billion in cash, and that’ll increase when they finish the sale of some more assets. Best, they only have $14 billion in debt.

I know it sounds like a lot, but look at Comstock’s cash-to-debt ratio.

Ouch again!

Chesapeake’s earnings are expected to grow 90% next year. And they have a growth estimate of 8.9% per year for the next five years.

These are good numbers for any company. But in the natural gas business, they’re amazing!

But, here’s where the fundamentals in the energy sector get really weird, and why you have to look beyond the yields before you invest.

There’s a Chesapeake bond that has a coupon of 6.125% with a nine-year maturity that’s selling for about 104, $1,040 per bond, and has an average annual yield of about 5.5%.

Really?

How can a company with numbers as bad as Comstock’s have a bond that only pays 0.2% more than Chesapeake’s? This makes no sense. But very little in the energy sector does.

As rough as the past year has been, Chesapeake still has no chance of defaulting – none! I can’t say that about Comstock. The Comstock bond, based on its numbers, should have a yield in the 9% to 12% range.

Rules for Retirement Income From High-Yield Bonds

In this sector you have to look way beyond the yield.

There are lots of bonds available in the energy sector that are paying huge returns, some as much as 10%, 20% and higher annually.

But be careful!

There are also lots of gas and oil companies out there that are leveraged to the hilt, loaded down with debt, no profits, with very little cash, who can’t pay their bills because the price of natural gas is so low.

That’s why, in most cases, their bonds are so cheap and the returns are so high. In this sector, you have to do your homework!

Because sometimes the numbers are just too bizarre…

The key to bonds in oil and gas is debt relative to cash, revenue, revenue growth estimates and growth over the period you’ll be holding the bonds.

As always, buy high-yield bonds with ultra-short maturities. I’m talking those less than seven or eight years.

This gives you a lot of market price protection in the inevitable sell-off in the bond market… When the bond sell-off finally happens.

As I always recommend, buy small positions in many different bonds for diversification. And for the sake of your retirement, don’t own just energy bonds!

You should also always stagger your maturities so you have at least one bond per year maturing for the next seven years.

But most important of all: Don’t be a rate pig!