A Junk Bond Opportunity

More than one current news article claims that high yield bonds in the oil sector are getting killed.  Citing cost of production higher than the current price, fear of bankruptcy is everywhere.

Just three weeks ago a skilled fund manager that I met said high yield bonds are a good sector with good prospects.  While his opinion is likely true in the overall case, it appears that oil sector bonds, a fairly large piece, may be the exception.

What should you do?

Every crisis contains an opportunity.  The self-off in the oil junk bond sector is likely to be too steep.  At the same time, oil prices may become low enough that some of the companies default or go bankrupt.  A careful shopper can still find value.

Things to notice:

  • The total cost of production only matters in the long run.  As long as variable cost of production is less than the selling price for oil, the business can hang on.
  • Some bond issuing companies have a lower variable cost of production than others.
  • Oil will not remain in the mid-$50s forever.

You need to search for companies that have lower variable cost of production, strong covenants in the bond issues, and have been sold off too sharply given their better fundamentals.

In the late 60s Warren Buffet made just this kind of investment in railroad bonds.  They were enormously out of favour at the time.  He bought nearly all of a single issue at a deep discount (80% or so) and eventually sold it for close to par.

Why?  The bond issue was one of the few that had hard asset security supporting it.  Railroads have vast and valuable real estate holdings and he knew this bond had a call on those.  In the rush to exit the sector, people sold it aggressively despite its underlying security.

Oil sector bonds may provide the same opportunity.  It is a great deal of work to find the good ones, but it will pay handsomely.

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact: don@moneyfyi.com  

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