Striking Oil

“Formula for success; rise early, work  hard, strike oil.”
— J.Paul Getty

2014 ended with a bang, the echoes of which are resonating into the New Year. There is much to discuss, but here’s a quick overview:

Overall, the fourth quarter was hostile to credit and very friendly to duration. The Energy Sector was the big story for the quarter.

We had an outstanding 2014, adding substantial performance through security selection. We lost a bit of ground to indexes in the fourth quarter, but we are particularly pleased that our multi-sector approach limited our downside compared to the drubbing that Investment Grade (IG) and High Yield corporate bonds took.

Oil prices have experienced a massive decline. We discuss some of our exposures, approach and the new opportunities that have emerged in sectors sensitive to this big change.

Overall, market volatility energizes us, as it creates opportunities for better long-term investments. We give some examples of the values we’ve already turned up in a skittish market.

MARKETS

After a strong rally in the first half of 2014, two abrupt changes in investor outlook drove a sharply bearish credit market in the second half:

1) A sudden and dramatic change in market expectations for emerging markets, particularly China and Russia, on top of continued concerns about European economies; and

2) a precipitous drop (more than 50% from the June peak) in the price of oil brought about by US supply growth, EM growth concerns, and, finally, OPEC’s decision to keep producing through the decline. The market appeared to take OPEC’s behavior as intending to slow down the US oil exploration industry and/or punish regimes like Iran or Russia.

These changes in market sentiment lead to:

a) weakening of both the Euro and EM currencies against the U.S. dollar;

b) a rally in long U.S. Treasuries, even as the short end of the curve began to build in a Fed rate hike in 2015; and,

c) a broad widening of corporate spreads, wherein energy and commodity credits and foreign issuers of dollar liabilities (a large and growing part of the U.S. credit markets) were particularly hard hit.

Rates rallied while excess returns to credit were relentlessly negative through mid-December, posing a stiff challenge to credit-oriented investors such as ourselves. The real winner in 2014 was the long Treasury Bond, delivering double digit returns as investors fled emerging markets and Europe for the comparative safety of U.S. Government obligations.

POSITIONING AND OPPORTUNITIES

While we took no positions for or against long Treasuries, we were gratified to achieve strong security selection. Our Corporate credit picks generally outperformed the broad credit markets in both the ebullient first half and the nervous second half of 2014, and our results were further buoyed by our valuation-based, multi-sector approach, which moved us away from Corporate credit towards Structured Products, a sector that weathered the credit storm particularly well.

Throughout the year we have favored Crossover names, CMBS and ABS, and loans over High Yield bonds. Crossover credits straddle Investment Grade and High Yield ratings. As spreads widened, we located a few more opportunities in energy-related areas and made incremental changes to portfolios. In early December, market conditions became bad enough that dealers were having trouble placing new structured and electric generation issues, presenting an opportunity to add some excellent values to eligible portfolios.

We like to take advantage of credits that are moving between IG and High Yield. We had several companies in portfolios that made this move – two up (Dell, Gannett) and two down (Avon, Odebrecht). We anticipated all of these except Odebrecht, and all were purchased at good value based on the ultimate rating.

Continued low interest rates and a strengthening U.S. economy are particularly favorable for the performance of commercial-mortgage backed securities (CMBS), the stand-out credit sector of 2014. The average income for US commercial properties rose 2.3% last year, spurring average property valuations to increase more than 8%, according to Moody’s commercial real estate price index. Strong property-level performance is a source of continued deleveraging for our CMBS holdings – the underlying real estate collateral tends to rise in value, while debt declines over its term. Furthermore, commercial mortgage rates remain near historic lows, providing a fertile refinancing environment for loans that are approaching maturity. For example, an elevated 40% (or $33 billion) of 2015 CMBS loan paydowns are expected to be in the form of borrowers prepaying their loans in spite of expensive prepayment penalties. Refinancing activity also brought uneven supply to the CMBS market in the fourth quarter, which allowed us a highly attractive entry point into durable CMBS credits that benefit from strong collateral, sponsorship, and structure. As an example, we participated in a junior triple B-rated tranche of a floating rate transaction underwritten by Citigroup and Cantor at a spread of 400bps over one-month LIBOR. The six underlying loans are secured by a portfolio that is well-diversified both geographically across several primary markets and by property type, and has strong equity sponsorship.

The asset-backed securities (ABS) holdings we purchase are typically well secured at issuance with conservatively-valued collateral. Furthermore, credit enhancement often builds rapidly through paydown of debt from loan collateral principal payments as well as from lease and interest cashflows. Improved fourth quarter valuations brought us opportunities such as Jetscape (a seasoned aircraft lessor secured by new Embraer aircraft on extended operating leases, issuing under the name “Eagle”) and Nations Equipment (which is well-secured by truck fleet and construction equipment assets). We also added positions from experienced originators of small business and personal consumer loans. Scheduled borrower paydowns of these one- to five- year loans quickly builds additional credit support under these notes. Finally, we participated in an embedded value securitization of life reinsurer RGA’s yearly renewable term life business at a substantial spread concession to RGA’s unsecured notes (“Chesterfield”). In our ABS positions, the lower price of oil is generally a benefit, as both equipment operators and consumers benefit from lower fuel prices and US borrowers enjoy incrementally higher disposable income. 

ENERGY WAS THE BIG STORY

The rise in spreads of energy-related credits has been particularly violent, reflecting the oil price decline. Because energy companies are typically hedged for approximately one year, it appears to us that the market is now discounting a long period of low energy prices. Six months ago one might have thought the markets were discounting high oil prices indefinitely. To us this seems like another example of markets extrapolating current trends far into the future.

Most of our portfolios have an exposure of around 5% to energy-related credits. While our research process doesn’t rely on specific forecasts of any commodity, we do spend time looking at the potential performance of our credits under a period of sustained adverse conditions. For energy-related credits, that means exactly what the markets are pricing in now -- a period of persistent low prices. All energy companies will be hurt by lower prices, but we invest in credits that should be able to service debt comfortably in this sort of environment.

Looking at pricing for energy credits now, it seems to us that markets are “throwing the baby out with the bathwater” reacting to this latest price drop. We are not “window-dressers”. When something we like goes down in price, we like to buy more. Generally, our worst-performing securities of 2014 are now larger or longer positions. It may be illuminating to describe some of those bonds here.

Two of our most volatile investments have been bonds secured by offshore oil exploration rigs and drillships under long-term contracts to national oil exploration companies. Odebrecht is an offshore drilling services provider to the Brazilian oil giant Petrobras, and Oro Negro contracts primarily to Pemex, the Mexican national oil exploration company. Both of these structures pay substantially more than the unsecured debt of the national oil companies, despite the additional security and clean title to collateral. They are also supported by the following factors:

The national oil companies have significant incentives to continue extracting offshore oil and use this equipment. The national oil companies are not only partially owned by their government’s, their extraction activity is a critical source of budget revenue, hard currency and the national priority of “energy independence”.

For both companies, offshore oil is recoverable at a lower marginal cost than other sources of oil. Each company faces large sunk exploration costs, but sunk costs are just that, and the company is better off recovering the oil. The Gulf depths in which Oro Negro is active may have recovery costs as low as $24/barrel, and are likely to be the most favored type of extraction in a low oil-price environment.

The rigs and drillships used as collateral for our bonds are the newest and most efficient of their type, thus they are much less likely to be idled as compared to each company’s total fleet.

Another investment that has not yet worked for us is Avon Products. Avon is a direct marketer of cosmetics and other products, with a valuable business in emerging markets. Our original thesis for this investment recognized that a new and credible management team is aggressively implementing key strategic initiatives to focus the company on its historically attractive direct sales business. Given modest leverage, excellent liquidity and minimal near- and medium-term debt maturities, we viewed the core business as possessing investment grade characteristics, with the future range of outcomes mainly a function of restructuring success. Avon has significant market share in Brazil, Russia, and Eastern Europe, however, and recent events in those countries have delayed the company’s turnaround. Operating results have suffered from both reduced demand and very unfavorable currency translations. As we had anticipated, rating agencies recently downgraded the credit, triggering a ‘stepped-up’ coupon on our bonds, which we had selected for that reason. As with the price of oil, it is important to look through shorter-term trends to longer-term debt service capacity. We see Avon making good progress on cost cutting, deleveraging, constant-dollar revenue and margin growth, all suggesting that the company has passed an inflection point.

Dislocation in energy also created opportunities in energy-adjacent sectors. Richard Wu, who follows REITS, Utilities and project finance for us, makes a strong case that the Northeast will face tighter electric supply conditions over the next few years as U.S. Government policies place coal plants at a disadvantage and regional system operators place restrictions on power imports. In December, dealers struggled with any new deals involving energy.  We located two new senior secured loans (Tenaska and Astoria) that were likely to benefit from tight supply conditions in the Northeast.  Difficult markets force concessions, and we were pleased to obtain these loans at both very attractive floating rate spreads and a big discount to par.

These are natural gas plants that benefit from ‘capacity payments’ (a stream of revenue paid simply for the plant being up and available) and/or enjoy a very high priority in the order of electrical sources used by their NY and Mid-Atlantic markets. As with pipelines and other utilities, these companies’ margins are not immune to the effects of energy prices, but volume is much more critical to credit capacity and, we believe, well-protected. Our ability to move across credit sectors into senior secured bank loans gave us the opportunity to take advantage of these excellent values.

As we write this, the first week of January is resembling early December, with oil testing new lows. U.S. Telecom companies will have to issue an enormous amount of debt into this market to pay for the record-setting spectrum auction, which may set up some interesting opportunities in a sector we have largely avoided. These are truly interesting and rapidly changing markets, which gives us confidence that we can add value through this latest credit cycle.

Sincerely,

Andrew P. Hofer
Head of Taxable Portfolio Management