Portfolio Commitment to Energy Sector Increased

The May-Investments mutual fund model reduced its position in high yield (junk) bonds in order to increase the portfolio’s commitment to the energy sector. In the model, the high yield bond investment was made in December 2008, during the midst of the bank panic. Bond prices have appreciated significantly since that investment was made, and the bond fund also paid investors double-digit yields (based on cost) in the interim. More recently, however, higher prices on these bonds have reduced their potential for upside as well as the yield paid to investors (based on current value). As a result, junk bonds have had a difficult time keeping up with the upward move in equities.

The December 2008 purchase of junk bonds represented an unusual “doubling-down” on the sector. Yields on some bond funds at that time rose to more than 20%, which would be roughly equivalent to paying a Price/Earnings multiple of only five on a stock with flat earnings prospects. However, at that time – flat earnings prospects looked pretty good, since earnings on the S&P 500 had gone into a freefall. Moreover, bond holders were in a better position to preserve wealth in the event that corporate defaults were widespread as a result of the Great Recession.

As it turned out, bankruptcies did not increase as much as many feared. Both stocks and bonds have rallied once the economy stabilized, but the risks born by stock owners during this time was much greater than the risks that bondholders faced. Some companies that went bankrupt actually paid bondholders 100 cents on the dollar after the bankruptcy, while shareholders in those companies have not been made whole. It may well have been a once-in-a-lifetime opportunity to invest in junk bonds at incredibly low price levels, but that time is past.

At current prices, the risk/reward trade-off is much different. It is much harder to justify a doubled-up weighting in the sector at this point. With the sale in January, the portfolios still typically have one remaining high yield bond fund position remaining, at least for now.

The proceeds from the sale were used to reinvest in a mutual fund that invests primarily in natural gas exploration companies. Apache Corporation, Anadarko Petroleum, and Devon Energy were top holdings as of November 30. The energy sector has re-emerged as a very strong part of the market as investor optimism about the market, and the economy generally, improves. Commodity prices have moved higher, vehicle miles travelled has recovered from depressed levels in 2008/2009, and it is possible that the inflation-panic trade (buy gold!) may be giving way to the recovery-induced-inflation trade (buy energy!). Research by BCA Research shows that during the past forty years, often times the energy stocks have outperformed following phases of increased economic activity, regardless of the direction of crude oil prices. The recent strength in crude oil prices merely reinforces the notion that if energy stocks are moving up, our portfolios want to have significant exposure to this key area. 

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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