December 2, 2014 / 6:00 AM / 5 years ago

Oil price collapse roils US junk bond funds

BOSTON, Dec 2 (Reuters) - Collapsing energy prices have hit hard U.S. corporate junk bond funds, putting them on track for their worst performance in six years by squeezing the exploration and drilling companies that have been among most active issuers of high-yield debt.

U.S. funds have played a big part in bankrolling the U.S. shale boom, gobbling up billions of dollars of junk-rated debt issued by energy companies to rapidly expand production.

But in recent weeks, prices of some of these bonds have collapsed as oil prices have tumbled by a third since June to four-year lows, sapping energy companies’ revenues and raising doubts about their ability to repay the debt.

Last week’s decision by the Organization of the Petroleum Exporting Countries to refrain from output cuts to shore up prices only piled more pressure on the market.

“We have been concerned about the quality of the smaller E&P (exploration and production) players,” said Ashish Shah, head of global credit at AllianceBernstein. “I think we’re in the phase where people are selling what they can sell,” Shah said, adding that his company had a light weighing on energy.

Many funds declined to comment on their exposure to the sector, but some have been clearly hit harder than the others.

Energy issues only make up 16 percent of nearly 2,300 issues covered by the Merrill Lynch High Yield Index.

But disclosures by major fund companies show many of the energy-related bonds they own belong to the most distressed category. It includes bonds with yield spreads of 1,000 or more basis points over benchmark U.S. government debt, considered a sign of financial strain. About one-third of the 180 total highly distressed bonds in the Merrill Lynch High Yield Index are energy issues with spreads greater than 1,000 basis points.

So far, high-yield mutual funds are up 2.82 percent this year, the worst performance since 2008, according to data from Lipper Inc, a unit of Thomson Reuters. Since the end of June the Merrill Lynch junk bond index has dropped 1.6 percent while its energy sub-index is down 7.1 percent.

HERCULES IN TROUBLE

Around mid-year many fund managers were still holding on to many of the most highly distressed junk-rated energy bonds. One favorite has been the debt of Hercules Offshore Inc, whose jack-up rigs are used for offshore drilling.

Heading into the fourth quarter, a who’s who of the U.S. fund industry held the company’s bonds, including Pimco, Franklin Templeton, Loomis Sayles, Avenue Capital Management, Legg Mason’s Western Asset Management and BlackRock, according to Thomson Reuters data.

But since early September, prices of Hercules debt due in 2021 tumbled and yields soared to more than 26 percent from 8.5 percent, according to Thomson Reuters data. Yield spreads widened to nearly 2,400 basis points, signaling a deepening default risk.

Early last month, Hercules Chief Executive John Rynd told an investment conference how the company had more room for maneuver than in the previous down cycle and should emerge stronger from the plunge in oil prices. One reason was that Hercules’ $1.2 billion in debt was unsecured, which typically means bondholders could not put a lien on the company’s assets. Rynd also said the company has acted to protect its balance sheet, including laying off several hundred workers.

“That’s never fun,” Rynd told the Jefferies Global Energy Conference. “But you’ve got to protect the rest of us and somebody has to take a bullet.”

However, recent fund disclosures have shown there are many more debt issues like Hercules lurking in junk bond portfolios, prompting investors to run for the exit after years of piling in. Junk bond funds saw net withdrawals of $14.2 billion this year, after $72 billion of inflows during the previous five years.

Marty Fridson, a junk bond expert at New York-based money manager Lehmann Livian Fridson Advisors, said energy-related defaults could surge above 10 percent as early as 2017 even without a recession or downturn in the U.S. economy. The current market-implied default rate for energy issues is about 4.58 percent, compared to about 2.6 percent for the entire high-yield sector.

Reporting By Tim McLaughlin; Editing by Richard Valdmanis and Tomasz Janowski

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