If you are a buyer of assets and a long-term investor, the recent turbulence in markets should be viewed as a welcome development. You may find this unusual, but I must admit that I enjoy periods of volatility. Not because I relish in the misery of others, but because volatility creates opportunity. And finding compelling investment opportunities for Young Research’s subscribers and our investment boutique clients is what I spend much of my time doing (it’s true, I have no hobbies).
It has been a tough slog over the last couple of years. Zero percent interest rates and trillions of money printing by the Fed has squeezed much of the juice out of the lemon. The margin of safety and prospective return on a wide range of financial assets has plunged as prices have soared.
You have to turn up every rock far and wide to craft a decent portfolio today. So when volatility soars as it has in recent weeks, you must seize the opportunity.
Where do we see opportunity today?
The epicenter of the current, shall we call it, mini-correction, is in the energy sector. Energy stocks are in a bona fide bear market. The S&P 500 Energy index, which includes the best of the best in energy, is down more than 25% from its high. Indices that track smaller players in the energy sector are down more than a third.
The selling has been harsh and indiscriminate. Both energy stocks and energy bonds have suffered. It doesn’t matter if the company is an oil producer, a gas producer, a coal company, or simple pipeline company. If it’s in the energy sector, chances are it has been dumped.
Bonds Offer Best Risk-Reward
Much of the punditry has been focused on the fallout in the stock market, but the action you want to watch is in the bond market. If you are an income investor, the bond market is where you will find the best risk-reward tradeoff.
Plunging oil prices put dividend payments at risk for many oil stocks (major oils not included), but outside of default, energy companies cannot willingly eliminate interest payments on bonds.
The yields on energy bonds have soared during the oil price correction. In the chart below, we present to you the option adjusted spread of the Merrill Lynch High Yield Energy index. The spread is simply the difference in yield between the Merrill High Yield index and comparable maturity treasury securities. At current spreads, high-yield energy bonds are trading at or near prior crisis peaks. A bad outcome is now priced into energy bonds and a bad outcome is what we may see.
But should a bad outcome materialize, it is most likely to be in highly leveraged oil producers. Oil is the commodity that has fallen 40% over the last five months, not natural gas, not uranium, and not coal.
So then, instead of being a hero and trying to pick a bottom in oil company bonds, why not buy the bonds of natural gas producers and other non-oil producing energy companies that now offer attractive yields, but no greater chance of default than last quarter?
This is the strategy we are advising for savvy investors like your fine self, and the strategy we are busy at work implementing for our investment management clients.
Don’t Go It Alone
The bond market is a treacherous place these days. The structure of the market has changed dramatically thanks to Messrs. Dodd and Frank. Bond dealer inventories are at historic lows and liquidity is tight. Opportunities in the bond market are fleeting. If you are navigating the bond market on your own, you are a brave soul. But if you aren’t following the market day in and day out, you are likely to fall behind the curve and miss the boat.
For those who prefer the white glove service of a bond advisor, Richard C. Young & Co., Ltd. crafts fixed income portfolios for investors.
Jeremy Jones, CFA
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