From a price-to-earnings standpoint, the energy sector is the cheapest sector in the S&P 500.
It can also be surprisingly stable at times. Pricing for West Texas Intermediate crude was down slightly in 2019, but for the most part it was fairly steady for the year.
Yet given this price stability and the perceived cheapness in the sector’s equity prices, there are few bidders for the stocks.
In fact, relative strength (a measure of market demand) for the sector is among the worst in the S&P 500.
From June 2014 to the beginning of 2015, oil prices dropped 55%. High-yield energy bonds dropped 27% in the second half of 2015.
The stress carried over into 2016, and 60 energy companies defaulted that year. Investors still haven’t recovered.
That market stress should be a thing of the past. But Andrew Forsyth, portfolio manager at BNP Paribas Asset Management, says, “It’s a fatigued asset class.”
“No one wants to deal with it anymore… no one wants to take the risk,” he added. “The results have been so dismal, even in a steady price environment, investors have just said, To hell with it. Until you guys can prove this can be profitable, we’re done.’”
But by then, it’ll be too late to get in at a value. In losing faith, these investors are missing out on a sector that’s uniquely positioned to rebound.
In fact, there is reason for optimism this year in particular – not only in the energy space but throughout the entire market.
“Markets rallying to new highs clearly indicates that marginal investors believe 2019′s no-growth earnings will make for easy comps in 2020 if the U.S.-China trade war abates,” said Nicholas Colas, co-founder of DataTrek Research.
I agree – earnings for 2019 are still coming in, but earnings growth has a chance to be negative for the year. And many research firms project near-double-digit growth for 2020.
These firms (and the investors who rely on them) shouldn’t forget, though – bonds of junk-rated energy companies were down nearly double digits in 2019, while the broader market was positive.
About 20% of those companies’ debts will come due prior to 2023, so investors who hope to trade them have little time to recoup the loss.
It makes sense to invest in the space with caution. Don’t forget the bond investing fundamentals, especially in environments like this one.
Remember your ABCs…
- Assume you’ll hold a bond to maturity. As my colleague Marc Lichtenfeld likes to say, “Never let a short-term trade become a long-term investment.”With this mentality, you should prioritize fundamentals when considering a bond. Look for companies with good credit ratings (BB and above), and if their bonds have dropped in value, ensure it’s a temporarily market slip – not an omen of ill health.
- Break up the portfolio. Diversify your holdings across a variety of sectors – even if you want to take advantage of companies with strong fundamentals in an underappreciated space like this one.This also applies to maturity. Use a bond laddering strategy (where one bond matures each year) to ensure that you’re not too concentrated in any one year, and to help with inflation.
- Coupon is more important than price. If a bond’s price teeters and you hold it to maturity, you’ll receive the same principal back – but if you sell because you weren’t planning on holding to maturity, you’ll take a loss.Your coupon, however, won’t change. You can count on that income to be consistent.
When investing in bonds – especially in a sector with this kind of reputation – it’s critical to keep the basics in mind. There’s a lot of opportunity in the energy space when other investors are shying away, but it isn’t for the faint of heart.