Premier Oil and the High Yield Hypothesis

During market dips, it is worth recalling the words of Warren Buffett –

“Be fearful when others are greedy; be greedy when others are fearful.”

Security prices go up and security prices go down, but the coupons paid on bonds go on forever – steady, predictable and reliable. While they offer no upside beyond the prospect of redemption at par, their downside is also limited, always provided that they do not default. And even in default, bonds rank ahead of shares, so while the equity of a company running into serious financial difficulties is likely to be worthless, bondholders may still recover something from the wreckage.

So bonds tend to outperform equities in bear markets, but underperform during a bull market. Thus, while the FTSE 100 has dropped by 13% since the end of May from 7000 to around 6100 today, the average price of the bonds quoted on the LSE’s Order Book for Retail Bonds (ORB) has fallen by less than 4%. The capital value of our embryonic High Yield Bond Portfolio has fallen by 8%, or about half-way between equities and investment grade bonds, with the worst performer being the Rea Holdings preference shares acquired last month, which tanked by 20% when the company announced disappointing interim results a couple of weeks later.

Clearly, a fall in the portfolio’s capital values is never welcome. But realistically it is to be expected at some point, and is compensated by the annual yield of 7.4%. As long as the bonds continue to pay interest on the due dates, then short term market fluctuations have limited relevance.

The more fundamental question is whether the portfolio yield accurately discounts default risk or, as the High Yield Hypothesis (HYH) postulates, over-discounts this risk, offering the potential for returns superior to those that could be secured on equities or investment-grade bonds over the longer term.

Even after the recent falls in security prices, only three bonds are trading below their par value on ORB – Eros, EnQuest and Premier Oil. The first two are ready in the high yield portfolio. The third, Premier, is, like EnQuest, an oil exploration and development company, and as such has been hit not only by general market risk but also by sector-specific risk as global oil prices have tumbled. With global oil production running at around 97 million barrels per day, against consumption of 94 million bpd, oil stocks are building up and there is downward pressure on prices. At some point, the market will be brought back into balance. If demand does not increase, then some sort of a crisis is likely to occur on the supply side, potentially including severe cutbacks in production, the bankruptcy of marginal producers, and defensive mergers among the survivors.

The crisis could go wider than that. In an uncharacteristically lurid leader published on Thursday August 13th entitled “The world’s producers are boiling in cheap oil”, the Financial Times predicted that continued low oil prices could inject dangerous volatility into international politics and destabilize major oil producers including Russia and Saudi Arabia. “Countries in dire financial straits may feel forced into aggressive responses,” according to the FT’s jeremiad. “Periods when the global balance of power is changing are also times when international tensions can flare up. We are perhaps in just such an era today. Policymakers around the world need to be on the alert for the conflicts and upheavals that may yet result.”

The test of the true contrarian is whether he or she is prepared to buy when the Barbarians are at the gate. According to the FT, that moment may be fast approaching for the oil industry. Right now, investing in the bonds of a relatively small, highly leveraged oil exploration and production company has all the appeal of the Loony Dook on a freezing New Year’s day.

Is the high yield bond portfolio the construct of an ice cool contrarian keeping his head while all about lose theirs? Or is it the reckless gamble of a foolish speculator who rushes in where more prudent investors fear to tread?

Only time will tell. In the meantime, following the precepts of the HYH, Premier Oil’s 5% bonds become the seventh investment within the portfolio.

Issuer: Premier Oil Plc
Coupon: 5%
Maturity Date: December 11th 2020
Payment Dates: 6-monthly on June 11th and December 11th
Offer Price: 81.18
Running Yield at Offer Price: 6.1%
Yield to Maturity at Offer Price: 9.5%
Nominal Amount: £1,000
Cost: £811.80 + £12.98 accrued interest + £5.75 commission = £830.53

September 11th 2015

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