(PUB) Investing 2015

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Energy Sell-Off Spurs Outflows and Bargain-Hunting Income Strategist | Sumit Desai

For junk-bond funds, performance has largely come down to the size of their energy weightings. The top two Morningstar 500 funds during the full year and second half of 2014 were Fidelity Capital & Income FAGIX and Vanguard High-Yield Corporate VWEHX . Vanguard High-Yield Corporate’s Michael Hong held a bearish view on natural gas prices, which in turn led to a 10% position in energy bonds. His fund returned 4 . 5% for the full year and lost only 0 . 4% during the second half of 2014 , easily outperforming the category over both those periods. Fidelity Capital & Income benefited from an energy under- weighting and its nonenergy equity holdings. Fred Hoff, the manager of Fidelity High Income SPHIX , was also light in the energy sector, as he believed commodity-price exposure would put addi- tional stress on high-yield issuers’ balance sheets. Finally, PIMCO High Yield PHYDX benefited from its higher-quality mandate, and that fund held a 10% position in energy-related bonds through 2014 . Funds with higher energy exposure included Janus High-Yield JAHYX and Metropolitan West High Yield Bond MWHYX . Janus High-Yield fell 4 . 6% during the back half of 2014 and squeaked out a gain of 0 . 7% for the full year. The fund held a 17% stake in energy bonds at the end of 2014 , which caused most of the fund’s poor returns. Metropolitan West High Yield Bond held a 20% -plus stake in the energy sector throughout last year and its returns suffered accordingly, returning 0 . 33% for 2014 and declining 3 . 7% during the last six months. We now hear more managers arguing that energy high-yield bonds are a great bargain. Carl Eichstaedt, comanager of Western Asset Core Plus Bond WAPSX , told us: “I think there are some big opportu- nities. There are some survivors and some companies that may not [survive]; but if you identify those that will survive, I think there is tremendous opportunity in energy high yield.” If the energy bulls are right, it could flip the script in 2015 . K Contact Sumit Desai at sumit.desai@morningstar.com

After a risk-led rally drove strong returns for high- yield bond funds from 2009 through 2013 , the cate- gory had a difficult year in 2014 . The group returned a paltry 1 . 1% on average last calendar year, and many funds posted negative returns. The category returned 4 . 8% on average during the first six months of last year but fell 3 . 6% during the last six months. This second-half decline was driven largely by plunging oil prices, which caused energy-related high- yield bonds to decline almost 13% in the last half of 2014 . Following the sell-off, just more than 20% of the high-yield energy sector is trading at distressed levels, with option-adjusted spreads over Treasuries topping out at above 1 , 000 basis points, compared with just 1% of the sector six months ago. Energy companies borrowed heavily following 2008 ’s finan- cial crisis, taking advantage of new drilling opportuni- ties, high oil prices, and low interest rates, causing the energy sector to increase from 10% of the Bank of America High Yield Master II Index at the end of 2007 to 15% near its peak in 2014 . By comparison, the energy sector makes up 8 . 4% of the S & P 500 . The late-year sell-off was exacerbated in December when investors pulled $9 . 3 billion out of high-yield funds, the second-worst month of flows for the cate- gory in more than 10 years. These massive redemp- tions caused broad-based selling across all high-yield sectors: Excluding the energy sector, high-yield spreads widened by 93 basis points during the second half of 2014 . Aside from the energy sector, funda- mentals remain strong. Defaults remain well below historical averages. Many investors believe the sell-off has created attractive opportunities, with the overall high-yield market now yielding close to 7% and the energy subsector yielding more than 10% .