By David Absolon, Investment Director at Heartwood Investment Management

The fallout from the collapse in the oil price last year permeated in many sectors, including US energy-related corporate credit. Consequently, the cost of financing for these companies nearly tripled in the second half of 2014 and the five-year credit default swap market implied that around 50% of these companies would default. We believe that the sell-off was overdone.

The recent stabilisation of the oil price provides welcome news and we are encouraged as energy companies have responded swiftly in adjusting to a lower oil price by dramatically reducing capital expenditure (according to some estimates by nearly 50% on average in the fourth quarter of 2014).  As a result of efforts to improve liquidity buffers and respond as necessary to the supply/demand outlook, we believe that energy companies are generally better positioned to manage the down cycle.

Inevitably, we are likely to see some casualties along the way, but we believe that current valuations (a yield to maturity of 8% and 650 basis points yield spread over the risk-free rate[3]) should more than compensate investors for the risk of default. A key catalyst for default is often an inability to meet or refinance maturing debt obligations. But to some extent this risk is mitigated in the high yield energy sector as less than 10% of the total bonds outstanding (nearly $200 billion[4]) mature over the next three years. It is also worth highlighting that default rates are historically low among energy issuers with better recovery rates than the broader market.

Pumpjack 1 (PD)Importantly, from a technical perspective, the high yield energy sector has the support of buyers willing to provide funding, including private equity and hedge funds. The primary and secondary debt markets are expected to provide reasonable levels of liquidity if companies need to raise funds, driven by investors’ demand for yield.

Although we retain our cautious view on fixed income from a duration perspective, we are willing to take credit risk if we believe that we are being compensated for it. In our view, the sell-off in high yield energy has been indiscriminate and presents a compelling valuation case. Therefore, we have taken niche exposure to this area of the market through the US dollar-denominated Legg Mason Western US High Yield Energy Fund.

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