More on Equity Catching down to Credit: The Case of Energy
September 28, 2015
Catching down? Energy names have overdone it.
After the 30-year bond bull market, traditional fixed income is becoming a more difficult environment. It implies a low yield environment which means investors must move up the risk curve in search of return. Alternative investment strategies implemented to respond to unusual–and potentially long lasting market conditions.
Central banks played a key role in boosting the last leg of this bull market by expanding their balance sheets through quantitative easing. Fuelled by the low interest rates, credit markets have had a very strong run in the last few years. Select markets actually have negative nominal yields due to technical market pressures. There is no mistaking this perversity, seen in the recent shift from positive yields to negative yields in Government bond markets.
The Fed and other central banks must ultimately embark on a path of rate normalization. The Fed missed their chance for the next 18 months, as they will not hike rates in the face of an upcoming presidential election. Thus renormalization of rates doesn’t look to happen anytime soon. Renormalization means a back-up in yields, but this a brave and foolhardy trade.
There are alternatives. Increasingly divergent global central bank policies are creating volatility in traditional fixed income markets. Further, idiosyncratic opportunities are prevalent in the broader credit markets. In certain circumstances this is creating opportunities to go long and short in both sovereign and corporate instruments.
Recent corrections have widened spreads considerably and there is a lot of potential mispricing across a range of areas. Energy and mining credits, in particular appear to have blown out. In the context of the increased market volatility and deteriorating fundamentals in oil markets, any trade needs to be reviewed from the gaze of a cautious risk framework. Let’s take a deeper look from a capital structure perspective.
Take the last 10 years of S&P 500 energy equity and S&P 500 energy cash bond yields. There is a clear yet complicated relationship there that is worth exploring on total return basis.
Relative value on a total return basis, not yield basis, shows the real story of performance. You see occasional periods where bonds outperform equities, but not so deeply as seen currently. In green is the “slice” of bond performance that contributes to stock prices, which shows another indication of how cheap stocks have become.
This logic lends itself to a slow-money, fundamentals-based trade. With $8 billion in cash and equivalents to growth their market share, Exxon common stock has seldom looked like a better investment.