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High-Yield Funds Place Different Bets on Energy Bonds

Positioning within the energy sector will play a major role in how these funds will perform in 2015.

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Sumit Desai: After a strong couple of years, the high-yield bond category had a difficult 2014. The category barely squeaked out a gain for the full year, and these calendar results do not tell the full story for the category. Most high-yield bonds declined in the second half of 2014, wiping out the gains from the earlier part of the year.

This decline was driven largely by plunging oil prices, which caused energy-related high-yield bonds to decline almost 13% in the last six months. Energy companies borrowed heavily in the past few years, taking advantage of new drilling opportunities and low interest rates. Just as homeowners borrowed against inflated home prices during the financial crisis, energy companies borrowed this money assuming oil prices would remain above $100 per barrel.

Certainly, this sell-off has created some opportunities. The broad high-yield market is now yielding close to 7% and high-yield energy bonds are yielding almost 10%. However, with oil prices now around $40 per barrel, many overleveraged energy companies face a very realistic risk of default. For this reason, positioning within the energy sector will play a major role in how these funds perform in 2015, and security selection will be of the utmost importance going forward.

Across our rated funds, examples of funds with above-average energy stakes as of their most recent reporting dates include Janus High-Yield (JHYAX), Neuberger Berman High Income (NHINX), Franklin High Income (FHAIX), and Western Asset High Yield (WAYAX). These funds performed poorly last year but could benefit if energy-related bonds rebound.

On the other hand, funds that tend to underweight energy bonds include ones like Lord Abbett High Yield (LHYAX), PIMCO High Yield (PHDAX), and Fidelity High Income (SPHIX). These funds have been bearish on energy bonds and have benefited on a relative basis due to their positioning. If defaults rise, these funds would benefit due to the underweight. However, if the bonds rebound, these funds might not participate in that upside.

Sumit Desai, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.