Oil rally lures nervous investors back into energy junk bonds

Yields on junk energy bonds have fallen to the lowest level of the year as investors scramble into the distressed oil and gas sector , despite the risk that a still volatile oil price could easily reverse a rally that has driven crude to its high for the year.

The fragility , underscored by 15 straight days in which the price of oil oscillated more than 2 per cent, has unnerved fund managers who have been forced to quickly cover or unwind short positions in energy junk bonds.
The $14bn of new capital that has flowed into US junk bond funds since yields touched highs in February has helped fan the current rally. Bank of America Merrill Lynch’s junk energy bond index returned more than 16 per cent in March, its best monthly performance since at least 1996.

Prices for bonds sold by Chesapeake Energy, Antero Resources, Williams Companies, Whiting Petroleum and Range Resources have all climbed to their highest levels of the year this week.

Yields, which move in the opposite direction to a bond’s price, on lowly rated energy debt have declined to 13.2 per cent from a high of 20.9 per cent in February. Meanwhile, the average bond price has advanced nearly 20 cents on the dollar, according to Merrill Lynch.

“It is mostly the distressed part of the market that benefited from this rally, a lot of triple C securities,” said Scott Roberts, co-head of high yield at Invesco. “Managers need to exercise caution as there is the potential where this year is like last year: we have a spring time rally, it lasts up until May and then oil starts to roll over again.”

Some groups that are expected to default or file for bankruptcy in the coming months have also seen bond prices bounce, indicating investors believe recoveries will be stronger than first feared.

Troubled oil and gas explorer Energy XXI , which filed for bankruptcy protection on Wednesday, has lifted the trailing 12-month default rate to 3.9 per cent from 2.1 per cent a year ago, rating agency Fitch said. Defaults in April have reached $14bn, the highest monthly figure since Energy Future Holdings defaulted two years ago.

Junk bond investors will pay close attention to talks scheduled for the weekend in Doha, where oil-producing countries are set to debate a production freeze.

While analysts have cautioned that a cap near current production levels would not alleviate the supply-demand imbalance, Brent crude has rallied to its highest price of the year.

A key risk remains that a global slowdown could crimp demand for gasoline and diesel, particularly if activity in China decelerates faster than many investors expect.

BlackRock noted on Wednesday that the recent oil recovery reflected “financial flows, not fundamentals, meaning supply versus demand and the impact on inventories that balance holds have gotten worse, not better”.

Henry Peabody, a portfolio manager with Eaton Vance, said: “You need higher oil prices to justify where we are today, which tells me that maybe we do see a bit of a pullback. The rally we have had is so sharp . . . it is reasonable to expect bonds to stall out a little bit.”