Oil Company’s Brief Life as Junk Means 85% Gain for Bond Tradersby
Prices on Encana’s 2034 notes have risen 85% from February low
Fallen angels have returned 17% this year, better than junk
First Encana Corp. was investment grade. Then it wasn’t. Then a month later, the Canadian oil and gas producer was high-grade once again.
Those twists helped prices on one of the company’s bonds jump more than 85 percent in what some fund managers said was among the juiciest trades of the first half of 2016. The notes also marked a sweet spot for the market -- recently downgraded debt, known as fallen angels -- that investors expect will continue to perform well this year.
“The real trade of this year has been to buy these fallen angels," said Patrick Flynn, a Chicago-based high-yield portfolio manager at Neuberger Berman, whose firm oversees $243 billion. "You’ve got the highest returns from being in really the best credits in those respective industries, which is a very unique opportunity.”
For investors in Encana, the ideal time to buy was in late February. Moody’s Investors Service cut the Canadian oil and gas producer to junk on Feb. 18, citing its high debt load. The company’s bonds due 2034, with a 6.5 percent coupon, plunged to around 55 cents on the dollar, compared with about 85 cents at the start of the year.
On March 14, the company obtained a new investment-grade rating from Fitch Ratings. Because most investors determine whether a company’s debt is junk based on the average of its ratings, the Fitch grade was enough to essentially make Encana investment grade again starting in April. The company’s bonds due 2034 are now trading at around 103 cents on the dollar, leading to returns from price appreciation alone of more than 85 percent for traders who timed the market well.
“I have never seen a company go from fallen angel to rising star in a month," said Neuberger Berman’s Flynn. "That’s a unique occurrence in my experience. So, clearly the trade of the year.”
Encana’s shares have seen a similar jump, closing at C$9.94 in Toronto on July 6, up from a February low of C$4.15.
Even for companies that haven’t returned to investment grade, the events at the start of the year made for an opportunity for nimble traders: many miners and energy producers were getting cut to junk, which depressed bond prices, just as commodity prices were starting to rally, which then boosted the notes’ values.
"The high returns for many of these bonds are closely tied to oil and other commodities prices, which started rising in the first two months of the year," said Pepper Whitbeck, head of U.S. high-yield at AXA Investment Managers.
Earlier this year, some analysts and investors sounded warning signs about fallen angels, which were expected to flood the junk-bond market and depress prices. In the first half of the year, there were $128 billion of fallen angels, compared with an overall high-yield market size of $1.48 trillion, according to JPMorgan Chase & Co. research.
Neuberger Berman boosted its exposure to Encana’s 2034 notes in the first quarter, according to data compiled by Bloomberg. The firm did not disclose when it purchased the debt, and Flynn declined to talk about the timing.
The Eaton Vance Bond Fund began to purchase Encana’s 3.9 percent bonds due 2021 in January and added to the position through February, according to Henry Peabody, who helps manage the $650 million portfolio. The notes, which closed as low as 64 cents in February, traded above 100 cents on July 6.
Prices on other fallen angels have also jumped this year. The Bank of America Merrill Lynch U.S. Fallen Angel High Yield Index rose 17 percent this year through July 6 on a total return basis, performing better than the overall U.S. high-yield index’s 9.9 percent. The gains are well above the median annual return of 8.2 percent for fallen angels over the past 10 years, according to a June 14 report by Bloomberg Intelligence analysts.
Freeport-McMoRan Inc., the copper miner that Moody’s cut to junk in January and S&P in February, has seen the price of its notes with 3.6 percent coupons maturing in 2022 more than double since its January low.
It will be difficult for fallen angels to perform as well as they have so far this year, said Oleg Melentyev, Deutsche Bank AG head of credit strategy.
“The strongest-performing sectors have basically gone a little too far,” he said. “We’ve had a good run, and I want to stay away from it.”
With the U.S. as a safe haven, fallen angels are attractive to many investors looking for yield, and there are few better alternatives, said Jack Flaherty, a New York-based money manager at GAM Holdings AG.
"You look at these companies and go wow, look how much they’ve rallied, but you want to sell them?" Flaherty said. "Well, to buy what?"