Williams Equity Research
The Numbers Don't Lie- What Are Credit Markets Telling Us About Risk In Energy?
Jun. 29, 2015 1:04 PM
- Energy debt pricing is volatile but informative.
- Probabilistic scenarios help explain what the market believes in terms of risk and reward.
- Investors across the capital structure - equity, preferred, and debt - should be cognizant of the market's expectations of default risk.
- Analysis includes the basics of bond pricing and returns as well as more sophisticated methods.
As noted in my previous article that discussed, in part, capital structure anomalies in the energy and exploration sector, the debt market is providing valuable information for investors whether they invest in equity, preferred shares, or debt.
This article involves a moderate amount of calculations but it is not imperative that their intricacies are understood by every reader. All results are explained in layman's terms. My objective is for investors with all levels of expertise to come away with something worthwhile.
There are many ways to value bonds. Some are purely quantitative while others are primarily qualitative. The prices of bonds, like most securities and investable assets, are ultimately determined by human decisions and not mathematics. We will examine what assumptions lead to the prices the market believes are accurate. This same methodology applies to all publicly traded firms with outstanding debt - not just the energy sector.
We will use two familiar names with significant leverage and two with more resilient balance sheets. This article is not intended to provide a comprehensive review of these firms' prospects but will provide insight into what the market believes.
Linn Energy, LLC (NASDAQ:LINE )
We begin with Linn Energy's 7.75% coupon CUSIP 536022AF3 Moody's B1 rated bonds maturing on 2/1/2021. These senior unsecured bonds are non-investment grade, otherwise known as high yield, and dated 8/9/2010. Senior unsecured bonds are toward the top of the capital structure and are among the first in line for repayment if a firm defaults. This tranche is always ahead of equity, preferred stock, and subordinated debt. Consider credit facilities, term loans, and any other financing arrangement that might be in front of the bond you are considering for investment. Linn's 10-Q provides transparency on the firm's obligations:
Here we see the often mentioned "10 billion in debt" when authors and analysts discuss LINE. Despite highlighting Linn's aggressive growth strategy and elevated financial leverage as two of the three rating drivers, Moody's does not have the debt issue "on Watch" nor has it revised the "Stable" rating outlook determined on 12/17/2013. This bond has traded with relatively high volatility since commodity prices declined markedly. Rating agencies are backward looking and I personally do not put much credence into their opinions. The facts incorporated into their analysis, however, can be useful.
For those less familiar with bond pricing dynamics/fundamentals, the basics are outlined before getting into more complex analysis of what the market is pricing in through current valuations.
Since the decline in oil in late 2014, prices have ranged from the mid 70's to mid 80's with the current price of 86.063 resulting in a yield to maturity (YTM) of 10.98%. This assumes (1) 12 semi-annual payments of 3.875, (2) all interest payments reinvested, and (3) receiving par value of 100 upon maturity. Scottrade has 11.073% as the YTM likely due to how it accounts for the timing of interest payments. I perform these calculations myself with a BA II Plus calculator so for consistency's sake I will use my figures instead of Scottrade's or another source. Any differences will be a small fraction of one percent and not material.
For novices on the subject, bonds are priced relative to par which is usually 100 or 1000. The current price of 86.063 equates to a 13.9% (par of 100 minus 86.063) capital gains loss if initially purchased at par. This does not include the distributions received. Since most corporate bonds make semi-annual payments, we'd need to add approximately four and a half years' worth of interest payments or
[(the annual interest rate divided by the number of coupon payments per year ) times the total number of payments ]
((7.75/2) * 9) or $34.875 per 100 of par.
The total return is then closer to 120.938 or a compound annual growth rate of 4.947% (we are ignoring taxes here which impact returns). This is not bad and would likely surprise many considering the bonds have taken a decent hit since the sell-off in crude oil. Assuming all remaining interest payments are made, the bond has a full recovery rate, and the investor receives the par value of 100, the YTM is 10.98%. The yield to call (YTC) is even higher under these conditions since the bond trades well below par and is callable at 103.875 and thus 3.875% above our assumption of receiving the par value of 100.
Now we will move on to more in-depth analysis and shed light on the risk the market is pricing in using real numbers.
With relatively straight forward mathematics we can also calculate the breakeven to determine at what point investors in this particular bond issue earn a flat CAGR (no gain or loss) including all interest payments under varying circumstances.
1) If the bond was bought at par value of 100 instead of today's price, the investor could receive as little as $53.50 upon maturity and would still maintain a CAGR of zero. Here and for the rest of the article we ignore tax implications since they vary by investor, make the math even more cumbersome, and don't have such a huge impact that it alters our conclusions.
2) If the bond was bought at today's price of 86.063, the investor could receive as little as $39.563 upon maturity and would still have no losses.
What do these numbers mean?
Taking into account the time to maturity of about 6 years, the bond's relatively high coupon of 7.75%, and the firm being able to at least making interest payments through the life of the bond, a recovery rate above 39.563% at maturity yields positive returns.
Now we will take the real world environment and Linn's prospects into consideration to refine the approach. Linn has been moderately successful in managing the crash in commodity prices. It has entered partnerships to relieve capital needs, engaged in several asset sales/swaps, and has a fairly strong hedge book for the next couple years. It does have a large debt load of approximately 3 times equity with sizeable maturities beginning in 2019.
This does not tell us exactly when Linn will face insurmountable financial stress but it does tell us that it is more likely to occur as its hedges roll off and meaningful debt comes due. We can assign probabilities to when default will occur and determine the corresponding return. To do this we need to consider the recovery rate at default. Recovery rates are actually quite high historically for senior secured loans, often 100 cents on the dollar. The recovery rate is smaller for subordinated and other lower tranches of debt. These factors depend on the firm's unique debt profile. For this analysis and based on LINE's specific leverage (unfavorable) and this bond issuance (senior unsecured), we assume three scenarios including moderately optimistic recovery rates of 66 cents on the dollar, a more conservative 33 cents on the dollar, and a worst case scenario of 0 cents on the dollar (representing a total loss on the senior notes). One can intelligently argue which estimate is the best. Our job is is to evaluate the impact of those assumptions. We will stick with the CAGR approach instead of dollar values because it is mathematically more meaningful and easier to scale. Assuming the bond is purchased at today's price of 86.063:
1) And default occurs in late 2018, the CAGR is:
a. 68% if the recovery rate is 66 cents on the dollar
b. -8% if the recovery rate is 33 cents on the dollar
c. -28.1 if the recovery rate is 0 cents on the dollar.
2) If the default occurs in late 2019, the CAGR is:
a. 1.76% if the recovery rate is 66 cents on the dollar
b. -4.5% if the recovery rate is 33 cents on the dollar
c. -18.06% if the recovery rate is 0 cents on the dollar
3) If the default occurs in late 2020, the CAGR is:
a. 2.41% if the recovery rate is 66 cents on the dollar
b. -2.34% if the recovery rate is 33 cents on the dollar
c. -12.38% if the recovery rate is 0 cents on the dollar
We will stop there since the bonds mature in 2021 and we already discussed the results associated with that.
What can we derive from these results?
If you believe that Linn Energy will at least remain solvent for the next few years and the recovery rate will be at least 33 cents on the dollar, it is not possible to experience worse than a -8% CAGR on your investment (note: review what this means if you are not familiar with this calculation - even a small negative CAGR can mean significant losses over longer periods of time). Considering the conservative recovery rate and the fact Linn is a highly leveraged firm in a difficult environment, this may be seen by many as surprisingly manageable risk.
If you are a little more optimistic about recovery rates after reviewing the firm's balance sheet and think 66 cents on the dollar is more applicable, you will not have a negative CAGR as long
as the firm stays in business for the next few years. This is a powerful conclusion. If we were to use a senior secured tranche and determined the specifics of Linn's debt profile, we could determine the expected ranges of recovery rates with some reliability. For this unsecured tranche and given the complexity of Linn's structure, the best I can do is use a range of recovery rates and perform scenario analysis.
Now we will examine an issuance from another firm with a different debt maturity profile and debt to EBITDA ratio, Breitburn Energy Partners (NASDAQ:BBEP ).
This senior unsecured bond CUSIP 106777AB1 matures on 10/15/2020 and has a coupon of 8.625. In early April 2014, this bond was priced at 77.265 with a YTM of 14.696%. The market has changed its mind on BBEP, however, and it now trades at 93.55 with a YTM of 10.223%. Here I use 5.5 semiannual payments of 8.625/2. Moody's is more pessimistic on BBEP and rates the bond as B3 with a negative outlook but remains "Not on Watch." This issuance was reviewed by Moody's on 12/18/2014 after oil's fall was well under well. We can see our debt issue under the long-term debt section of the 10-Q:
BBEP has a significant amount of indebtedness outstanding under its credit facility. This issuance is comparable to Linn's in the sense they are both senior unsecured with similar attributes. BBEP used to be priced at a significant discount to LINE in April 2015 but that gap has closed. BBEP's debt maturity schedule was posed to put stress on the firm's financial position about a year sooner than LINE but they entered into agreements to alleviate much of the situation. BBEP bought (and some would argue paid a heavy price for) additional time/flexibility surrounding its debt maturity schedule through its recent $1 billion deal with EIG. Despite BBEP's strong hedge profile, its recent operating performance suggests it is still going to face significant challenges over the next couple years without a substantial recovery in oil and natural gas prices.
While the market now prices BBEP's risk similar to LINE's, let's do an analysis on BBEP back when it was under much higher stress and the issuance was priced lower. This gives us an example on how to price moderately stressed debt; results will be consistent for any bonds priced in this range with similar characteristics including maturity and yield. Reference the higher recovery rates for firms with less leverage and vice versa for those with higher leverage than BBEP prior to the EIG deal. Investing in the debt of firms with a high probability of default already priced in, such as Energy XXI (NASDAQ:EXXI ) and Goodrich Petroleum (NYSE:GDP ), will result in more favorable results than discussed below if they manage to stay afloat.
For BBEP, we are going to assume default could occur one year sooner than LINE and lower our expectations on recovery rates but otherwise keep the variables and methodology consistent. Assuming the bond is purchased at April's price of 77.265:
1) And default occurs in 2017 the CAGR is:
a. -3.75% if the recovery rate is 50 cents on the dollar
b. -15.96% if the recovery rate is 25 cents on the dollar
c. -41.24% if the recovery rate is 0 cents on the dollar
2) If default occurs in 2018 the CAGR is:
a. -.35% if the recovery rate is 50 cents on the dollar
b. -8.25% if the recovery rate is 25 cents on the dollar
c. -24.46% if the recovery rate is 0 cents on the dollar
3) If the default occurs in 2019 the CAGR is:
a. 1.37% if the recovery rate is 50 cents on the dollar
b. -4.19% if the recovery rate is 25 cents on the dollar
c. -15.1% if the recovery rate is 0 cents on the dollar
What can we derive from these results?
We observe a lot more negative numbers here. In fact, only if the firm made it through 2019 and the recovery rate is 50 cents on the dollar will any of these bankruptcy situations result in a positive CAGR. Based on these parameters, investors were taking on significantly higher risk for the additional 3.6% in YTM for BBEP versus LINE. Despite what looked like a significant differential in YTMs of 11% for LINE and 14.6% for BBEP, I would surmise the market had not adequately discounted BBEP's debt relative to LINE to make it attractive back in April. BBEP would have needed to decline further into the low 70's/high 60's before I think the risk adjusted returns were comparable to LINE.
Now let's do a cursory analysis of two better capitalized names in the energy space that are considered investment grade.
EOG Resources Inc. (NYSE:EOG ) has an A3 senior unsecured issuance CUSIP 26875PAD3 with a 5.625% coupon, current price of 113.827, maturity date of 6/1/2019, and a YTM of 1.94%. It is non-callable so we do not have to take that risk into account despite it trading over par.
What can we conclude about this higher quality issuance?
This is a totally different picture versus LINE or BBEP. The market is pricing in almost no risk which can be defined as the spread of these bonds versus "risk-free" government bonds. Using the treasury's posted yield curve rates. we can see the 5 year equivalent rate comes in at about 1.55%. The risk premium is only half of one percent. On top of that, if EOG were to face issues prior to the debt maturing, the significant premium paid over par now works against us and magnifies our losses. I like EOG and have always been impressed with their engineering advancements and overall operational efficiency but this risk premium is not high enough for these bonds to look attractive at current valuations. I would consider these bonds favorably priced if within 5% of par and that would assume I believe WTI would level out at no lower than $60/bbl within 3-4 years. This is based on EOG's strong liquidity and overall financial position.
Total assets are 5x long-term debt. It is difficult to imagine a scenario with any real likelihood in which EOG is unable to make interest and principal payments on senior debt between now and 2019. EOG posted a small loss in comprehensive income for Q1 but the firm also took non cash charges (e.g. Depreciation, Depletion, and Amortization) of approximately $1 billion dollars. These represent accounting losses rather than actual cash expenses incurred by the firm.
As we did with LINE versus BBEP, we will use Continental Resources, Inc. (NYSE:CLR ) as the investment grade comparable but deemed higher risk than EOG.
CUSIP 212015AH4 is a senior unsecured issuance rated Baa3 currently priced at 99.731 with a 5% coupon, maturity date of 9/15/2022, and 5.044% YTM. Its yield to call isn't a factor since it's trading at about pa is slightly lower since it is callable in Q1 2017 but we'll ignore that here since the impact is marginable (4.481% versus 4.62%).
The spread over treasuries, this time using the 7 year rate of 1.93%, widens considerably to 307 basis points or just over 3%. Investors incur more interest rate risk here since the bond matures two years later than EOG's which is going to be a part of this additional spread. CLR's abandonment of its hedging program means it is at higher risk than previously in being unable to produce sufficient cash flows to support its debt obligations. The longer timeline associated with the bond also decreases the reliability of forecasting cash flows. Whether or not CLR's issuance is priced favorably to EOG's is a matter of opinion and an individual's risk tolerance. I would not consider investing in EOG's debt given the miniscule spread over the treasury yield curve and price well above par. CLR's issuance at least provides the potential for decent fixed income returns of 5% before taxes.
While this article covers the first layer of analysis, investors would ideally also assign probabilities to individual recovery rates and timelines then build a decision tree before making a final investment decision. If there is significant reader demand for this on a few names I'd be happy to take that on.
Some issuances are quite attractive and already have significant risk priced in. Others trade basis points higher than treasuries despite functioning in one of the more difficult oil and gas environments in recent history. It is worth considering the potential upside and downside of debt securities before investing lower down on the capital structure in preferred or equity shares. Equity and preferred shares are likely to be worth zero when the firm enters bankruptcy and thus there is no recovery rate factor to potentially augment returns if the firm becomes insolvent. It is often worth evaluating the allocation of part of your equity exposure to the debt component as part of an overall risk management strategy. This is especially the case if your expected rate of return on the common equity is not far from what is already available through investing in the firm's debt.
Disclosure: I am/we are long LINE, BBEP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has no positions in the debt of any of the names mentioned in this article but may enter long or short positions in the common or preferred equity of these names at any time.