Saturday, December 6, 2014

Unintended Consequence of Falling Oil

Before oil prices began their plunge this summer, energy-focused private-equity funds had outperformed general private-equity funds over the past decade, returning about 16.5% annually, after fees, compared with 14% for the general funds, according to Cambridge Associates LLC. The big returns prompted private-equity investors to double down on drilling.
Nearly $100 billion has been pumped into energy funds since 2011, according to data provider Preqin.
For most of the year, private-equity firms ran into each other in auctions bidding up prices for drilling properties that big oil companies sold. Through mid-October, private-equity firms had been the buyers of roughly a third of the $54 billion of U.S. onshore oil and gas fields, according to RBC Richardson Barr, a Houston unit of Royal Bank of Canada. As oil’s slide steepened, the deal market slowed, though.
Private-equity firms sized up California oil fields that Freeport-McMoRan Inc. shopped recently, according to people familiar with the matter. Some of the suitors gave up pursuit of the properties valued at $5 billion because they were unable to borrow enough of the purchase price to earn the profits they were after, the people familiar with the matter said.
As for done deals, private-equity firms often have some protection.
Even as they were downgrading Laredo’s stock to “neutral” from “overweight,” Simmons & Co. International analysts last month said the Tulsa, Okla., company “has a number of things working for it,” including the $88 dollars a barrel it will get for most of the oil it pumps next year. Laredo has hedged about 85% of its expected output in 2015, which is well above the 35% average for other energy producers it studies, the investment bank said.
Warburg and its investors, which spent about $600 million launching Laredo, have already pocketed about $1 billion from the investment, so proceeds from any shares the firm still owns is gravy.
EP Energy, which has also hedged much of its near-term output, is basically a break-even deal for Apollo at the current share price, down from about double the firm’s money when it sold shares in its January initial public offering. “We feel good about the long-term prospects of that investment,” said Mr. Harris, the Apollo co-founder.
And despite Antero’s recent slide, which has lopped about $4 billion since June off the shares still held by Warburg and partners Trilantic Capital Partners and Yorktown Energy Partners, the investment firms have already pocketed about $1 billion on their roughly $1.5 billion investment in the Denver company.

Tuesday, November 4, 2014

Bonds in a Rising Interest Rate Environment

Article excerpt by D Blitzer from S&P Dow Jones Indices

After last week’s FOMC meeting, the time when interest rates begin a sustained rise propelled by the Federal Reserve may be drawing closer.  The received wisdom is that no one should own bonds when interest rates are rising because rising rates mean falling bond prices.  While the math demands that bond prices fall, a deeper look at the math reveals that all may not be lost.

Some investors believe that the yield to maturity on a bond measures the return they will earn if they hold the bond until it matures.  Not quite. There is a hidden assumption that the coupon payments received every six months will be reinvested and will earn the same rate as the yield to maturity.  Since interest rates can vary over time and different rates are available for different time frames, this assumption rarely holds.  When interest rates climb after a bond is issued, the price of the bond drops but the returns earned from reinvesting the coupon income benefits from the higher interest rates.  (The reverse also holds, if rates fall after the bond is issued, its price rises but the returns or “interest on interest” from reinvesting the coupons is less.)  If you buy a bond and interest rise far enough and fast enough, you might do better than if rates never moved at all.

A made-up example shows how this might work and how the investor who holds the bond long enough could benefit.  The table shows a theoretical investment in a 2.5% coupon ten year Treasury note bought on January 15, 2015 at a price of 100.  The yield to maturity when purchased is 2.5%.  If rates don’t change and if each semi-annual coupon payment of $1.25 can be invested at 2.5% annual rate for the remaining life of the bond, the investment will be worth $128.20 on January 15, 2025 when the bond matures. The dashed purple line on the graph illustrates this; the right hand scale is the value of the investment in the bond and the coupons.

Now let’s change the example shown on the table – interest rates rise and the yield paid on newly issued treasury notes rises towards 7% as shown in the second column of the table.  Further, the coupon income is reinvested in six-month T-bills which pay 1.25% less than treasury notes.   The table works out this example: every six months a coupon payment is received and it is added to the past coupon income and the total is invested at the T-bill rate. These coupon payments – the interest paid on the bond – earn “interest on interest.” At the end of ten years the accumulated coupons total $31.10 ($25 of payments plus $6.10 interests earned on the coupons). The total investment is worth $131.10.  The green line on the chart plots the investment value.  In the early years the rising rates depress the bond price and send the investment into negative territory.  As the accumulated coupon interest increases and as the bond approaches maturity, the investment moves into positive territory and surpasses the theoretical case of no change in interest rates (the dotted line).


If it is possible to make money with bonds when interest rates rise, why are so many people worried that rates will rise?  The blue line at the bottom of the chart plots the price of the bond for the same time pattern of rising interest rates.  Just as the math requires, rising rates mean lower bond prices. 

At maturity approaches the price approaches the par value of the bond – the principal to be repaid at maturity. If an investor didn’t reinvest the coupons, if instead he spent the coupon income, all he would have at maturity is the par value.  Likewise, if   the investor had sold out at the low point on the green line (July 15, 2016) the proceeds for the $100 invested would have been $96.50, a loss of $3.50.

There are no magic formulas for bond investing in any interest rate environment, but working the math sometimes helps.

Tuesday, September 30, 2014

Moody's Upgrades J.C. Penney Bonds

Moody's Investors Service recently changed J.C. Penney's rating outlook to stable from negative. 

The change in outlook was prompted by the successful closing of $400 million senior unsecured notes which will be used to fund the partial tender offer for J.C. Penney's $200 million 6.875% notes due October 2015, $200 million 7.675% notes due August 2016, and $285 million 7.95% notes due April 2017. 

At the same time, Moody's changed the Speculative Grade Liquidity rating to SGL-2 from SGL-3 due to improved operating performance and extension of the debt maturity schedule.

Sunday, September 28, 2014

Five Reasons Bill Gross is not likely to have the success at Janus that worked for PIMCO.

1. He is going to work from his home in California while the Janus headquarters remains in Denver.

2. The research staff at Janus pales in comparison to the team at PIMCO

3. Large institutions are not likely to leave the worlds largest fixed income manager - PIMCO for a firm with it's largest fixed income funds that measure in millions versus trillions.

4. Janus appeals largely to retail investors

5. Interest rates are directly opposite where they were when Bill Gross started PIMCO.