We Like Energy and Bonds – Why Not Energy Bonds? Jarvis® Update October 7, 2022

We like energy. We like bonds. Do we like energy bonds? We answer that question and more in this week's Jarvis Update. I'm your host, Brian Dress, director of research here at Left Brain, joined as always by our CEO and chief investment officer, Nolan Langford. Nolan, welcome to the program.

And you forgot to say the number one Dolphins fan. My Dolphins need a win this week at the Jets. Happy to be on the show.

Hey, good luck with all that. All right. A quick preview before we get started. It was a nice bounce back week for markets after the horror of last week. We got two topics to discuss for you, as we usually do. The first is answering the question, are we getting close to the top on interest rates? And then the second is energy and energy bonds. But first, before we get started, a few announcements for you. First of all, we produce this show for you, the everyday investor, whether you have a 401(k) or an IRA. You manage your own investments or you work with an advisor, we'd love to be a resource for you. If you'd like a second opinion on how to position your portfolio in a different— difficult market and want to hear more about the opportunities we're finding, particularly in fixed-rate securities, definitely contact us on the number below and we'll have a conversation, see if we can be a fit for you. Also, if you're an institutional investor, we've got something for you as well, and that's our research service, Left Brain Investment Research. 8 to 10 full-length stock reports per month. And also the Chosen List. That's our favorite bond and stock opportunity each month. So check that out. We'll put the details on the screen as well. If you want to get access to our library of hundreds of reports, either way, sign up for our biweekly newsletter. We don't have a newsletter this week, but we will be out with other content. So definitely sign up to be on the mailing list and receive that in your inbox every Saturday morning. Finally, if you find this video useful, make sure to like and share the video. It helps other investors find it. And also subscribe and hit the bell for notifications. You'll find out every time that we've got a new video out. So let's just jump right into the market recap. First of all, we follow 3 indexes here. They were all up this week. S&P was up around 2.9%, Nasdaq up 3.1%, and then the small-cap index Russell 2000 up 4.6% over the last 5 days of trading. A nice reversal to last week. And we also continue to note the outperformance of the Russell and small caps. We continue to look for opportunities in small and mid-cap stocks. They seem to be bottoming. Also, energy stocks are up double digits this week as measured by the XLE. That's the ETF of energy stocks. We also saw strength in financial stocks, industrial stocks, material stocks, and in healthcare. Oil was up 9%, and we'll get into that a little bit more as we talk about the OPEC meeting. Also, 2-year treasuries, that's been the, the highest rate in the whole treasury curve still are in excess of 4.2%. So interest rates continue to rise. Nolan, with that all in mind, what are your initial thoughts on this week's action?

Yeah, there was a lot there, a lot to digest. It was good to see some green on the screen this week. You know, last Friday we closed with that big belly flop of a close. We opened last week Friday very strong and we closed on the lows going into a weekend. It can create a scary situation for Monday. But we bounced strongly on Monday, held those gains through to Tuesday. We've been kind of seesawing or waffling since then, but it sets us up going into tomorrow's big jobs report. So it'll be interesting to see how we come out of it. The other thing that you said stuck out to me is the small caps. We've been noting the action in small and mid caps for a number of weeks. And I think that's an interesting tale. That's a lot. There's a lot to digest there. Maybe some of it has to do with the US dollar. For those viewers who may or may not follow what's happening in the currency markets, the US dollar has been extraordinarily strong this year. It's caused a lot of pain to overseas markets 'cause we're exporting inflation. But for US multinationals to get their revenues abroad, it also weakens their earning stream because they have to repatriate that currency back to the US dollar. And when the dollar's strong, that creates an issue with their earnings. But small caps are typically all domestic. So all the revenues are in US dollars because most of their sales are US-based. And so maybe that has something to do with it. The other thing that we've noted for several weeks, small and mid-cap stocks are very digestible for Fortune 500 companies. So to the extent you're some big company and maybe your organic growth rates aren't what investors expect, one of the ways to get a boost in your growth rates is to buy some other company. Smaller companies are easier for them to either issue stock or write a check for. So that could be the other thing, maybe adding something to the small-cap bounce.

Thanks, Nolan. And I want to reach out to the viewers and let them know, check it— check us out in the show notes, reach out to us if you want to hear about some of the small-cap and mid-cap opportunities that we like. And we certainly do like a few. With that, we'll jump right into our topics. Topic 1, the question is, are we close to the top on rates? We had a series of Fed speakers again, yet again this week, reiterating their aggressive posture to tamp down inflation. Nothing new, but they still want to keep talking about it. The 10-year was— for 10-year Treasury was 4% last week. It dropped all the way to 3.6% this week, and it's back to 3.8% at the time that we taped this. So pretty amazing volatility in interest rates. We also saw the biggest week of inflows to high-yield bond funds according to Refinitiv Lipper since August 3rd. So Some crosscurrents here. We see, you know, TLT falling. We see rates going higher, but people are starting to put money to work in high yield bonds. So that's a good sign. But we did see weakness in high income stock instruments. There are a few ETFs that we follow. BISD, that's an ETF of business development companies or BDCs. We've got REM, that's an ETF of mortgage REITs. That's another set of high yielding companies. And then MLPs, mostly pipeline companies in the oil space. All of those were weak this week. They're all high yielding from a dividend point of view. So that may have something to do with rates as well. We'll mention again that mortgage rates continue to rise. Most recent reading is just below 7% on the 30-year fixed. So again, interest rates are on the rise. Nolan, how do you interpret all these conflicting data on interest rates?

There's a lot happening. And what it tells me is that the credit markets are driving the stock markets. And so for traditional investors and traditional stock investing, it's making you raise one eyebrow to look over the fence and see what's happening in the— and not only the currency markets, but especially the bond and the interest rate markets. And with all that action that you mentioned in the alternative income space, it tells me that there's probably some liquidity or funding issues that are showing up, 'cause all of these are alternative income streams, whether they're the mortgage market, the REM, especially the business development companies. If liquidity's an issue, then those companies and those stocks don't act right. We have heard news this week that Credit Suisse, the big European bank, is having some capital issues. So that could be part of it. We know last week the UK had the issue with the prime minister. They wanted to cut taxes while rates were going up. Both of those policies, directives, are in conflict with one another. So we've seen these stresses, and then we've also heard news that there was a big technology buyout earlier this year. Citrix Systems is the name, uh, and they were bought out by a private equity shop. They couldn't get funding to issue those bonds to get the deal done, and they've been trying, and they still couldn't get a deal done. Uh, and so they've had to raise rates to do it. So that tells us that funding liquidity is an issue. And so until that gets settled, settled, it's going to be really tough for the markets to really put in a sustained bottom. Okay.

No, let's forget the stock market for a minute. I guess the question that I think a lot of investors are thinking, because this is driving everything, are we getting close to the end on rates rising? And then what do we want to buy when the Fed does finally relent, stop raising rates? What is going to be the best opportunity for investors?

It's a good question. We've been doing a lot of work here talking about, hey, when rates do peak, that is going to be a signal that it's time to put some money to work and do some buying. Question becomes, if everything's on sale, both stocks and bonds are down this year, where do we go and what things are likely to rise faster? And how can you position yourself to take advantage of a recovery? We do think one is on the horizon. I do think, and our data shows that they're probably close to the top on interest rate increases. And then at some point over the next 18 to 24 months, they'll probably start cutting rates. And so you want to position yourself accordingly. So we do have a list of stocks we like, but what really gets us going is the list of bonds. And so we think the bond market is a very attractive place to put some money to work to get fixed income. And if you buy fixed income right, you also have an opportunity for capital gains if you're buying these bonds below their maturity value. And the Federal Reserve Board starts cutting rates.

Well, thank you for that, Nolan. A brilliant segue into our second topic. So topic 2 is energy and energy bonds, a continued theme. So we've been talking about energy for the last few months. We've been talking about bonds. The question is, are energy bonds the right play? Let's talk a little bit about what's going on in oil. First of all, OPEC, that's the oil-producing cartel. They announced a 2 million barrel per day cut at this week's meeting. So that made prices rise. Pretty precipitously. Oil was up 9+ percent this week. We like energy, we like, we like bonds, so of course we do like energy bonds. Uh, first question, Nolan, what's your takeaway from OPEC, and, uh, is there an energy bond that you like particularly well?

You know, we could probably have had a whole section and session on energy. There's just a lot to unpack. A 2 million barrel cut to oil production, just so the viewers are aware. We haven't had that, uh, since COVID and that's when the worldwide economies were shut down. So that's just a huge, huge increase. It's like throwing a 99-yard touchdown. You don't see those every day. And, and so that needs to make news. And I'm not surprised oil jumped 9%. And basically the oil producers are saying enough of the oil slide. Supplies are already low. We're going to make them lower and really going to support energy prices. And as an investor in energy security, that should give you heart and should make you have a higher degree of confidence that cash flows are going to hold up for these energy businesses. Strong move.

Excellent. And then let's talk about what can we do as investors specifically in taking advantage of these situations. Tell us about a couple of energy— one or two energy bonds that you like that you think investors might want to take advantage of in the current environment.

So if we step back a little bit, this has been a tough year for investors. Both stocks and bonds are down. But if there's one sector that's up, it's still energy. Uh, the energy sector peaked in early June. I think it was about June 10th, and then it's been in a huge correction. So these energy businesses, stocks are still showing gains, just not as much as they were. If you go back earlier this summer, the energy businesses themselves in general are very healthy. At $80 to $90 oil, cash flows cover their costs manyfold. Most oil companies, a lot of them pay dividends. And from a cash flow standpoint, they have enough to not only pay their debt, but a lot of them have gotten credit upgrades. And that means as a credit investor, you're in a very strong position. But with everything that's happened in the interest rate markets and the liquidity markets, the bond prices have not kept pace. In some cases, bond prices are down on a year-to-date, even though the stock prices for the same energy businesses are up. This is the— this is a divergence as investors we think is investable and is a way to sort of take advantage of a snapback.

Excellent. You got one that you want to throw out, throw out for the viewers and we can kind of talk through it?

Yeah. One of the names that we really like is a mid-cap energy company called PDC Energy. I believe it's about a $6 billion business. They expanded their acreage during COVID by expanding with another mid-tier oil producer, and they produce oil and gas. Cash flows are very healthy, debt levels are low. They have a bond that's a 5.75% bond on a coupon. It matures in 2026. And I believe when we looked, we could buy this bond well below par. I believe it was someplace in the low 90s. And so you're getting well over 7% yield to maturity, and you have capital gain appreciation. The bond's going to mature at par as long as there's no default. And we get that 5.75% based off a $1,000 value bond between now and maturity date. We think this is a very, very attractive bond. The stock is up a lot year to date. Cash flows are improving, and this is a very healthy business. In a healthy sector, which is energy. So it's a name that we think is very attractive for investors to consider.

Excellent. And I want to talk a little bit about portfolio management and how, how investors should proceed. It's been a difficult time, but, you know, interest rates aren't going to be high forever. Can you comment on the urgency with which investors need to lock in some of these passive streams of income before rates start to fall again?

I think now is a really good time to start buying some of these bonds. Again, if you go back, It was only 3 to 4 weeks ago, some of these bonds were trading at their maturity value. We call that par. And just so we're— everybody's on the same page with the viewers, the bonds are issued at $1,000. They mature at $1,000 at some point in the future. And then in the meantime, the investor gets the coupon rate as income. So if there's a $1,000 bond that's issued and it's a 5% coupon, the investor will get $50 in interest payments per year. But between when the bond is issued and when it matures, it can trade above the maturity value or below the maturity value. And therein lies the opportunity. The last 4 to 6 weeks has been really tough in the markets. Liquidity hasn't been great. And so a lot of these bonds, the businesses are just as healthy and they're doing just as well. There's not a credit issue, but because there's not as many buyers around and people are nervous, Some of these bonds are issued now below their maturity value. So you can snap up some of these bonds cheaply and see them appreciate handsomely. Even when things go back to normal, doesn't have to be an interest rate change, it could just be investors feeling better about the economic environment, liquidity getting back to normal, and some of these bonds can appreciate. However, you're right, if we're correct, and if the Fed if what they've telegraphed comes to fruition, what they've telegraphed is they're gonna raise rates a little while longer. And then over the next 2 years, they're gonna start cutting rates. The way that bonds work, it's, think about it like a big, being a big seesaw, interest rates down, bond prices up, and vice versa. So, you're right. For investors, particularly those retirees living off of income streams, we think it's a very attractive time to start looking at buying a bond portfolio. You can create a bond ladder. You can get some really good coupons. We have bonds in our database with coupons from low as 2%, but some as high as 7% on a coupon basis. And some bonds are trading as low as $0.70 on the dollar. Some are trading much more. But you can create these interesting income streams based off of your needs. You can lock in that income today and you don't really have to worry about what the Fed's doing or interest rate changes. and you can lock in this income stream at a much cheaper price today than you could have 4 to 6 weeks ago.

Thank you, Nolan. If for the investors out there who are interested in, in a bond strategy, we're following nearly 900 bonds here at Left Brain, uh, on a weekly basis. So definitely reach out to us if you wanna hear more about how to get into individual bonds in your portfolio and how that might be a fit for you. With that being said, Nolan, anything you wanna leave the investors with? As we bid them adieu this week?

Yeah, you're right. I know it's been a tough time in the market. It's been a tough 3 quarters, but we think opportunities are coming and now it's time to get out the shopping list and take action. I know a lot of people have sort of been hunkered down, people that aren't working with advisors or maybe haven't looked at your statements in a while. For our clients at Left Brain, we do that constantly and we always on the lookout for opportunities, but we think it's time for people to get active. We think that there's some very attractive opportunities that are out there. We'll really be paying attention to earnings. Earnings start next week, a week from tomorrow. The banks report earnings, and the week after that we get— we're going to get a bunch of, uh, companies that report. We'll be interested to see how companies report, how they're doing in this environment, and more importantly, how investors respond to these earnings reports. So reach out, we'd love to talk to you. We'd love to do a portfolio review and talk about some of the opportunities.

Thanks, Nolan. Thanks to the viewers, and we'll see you again next week.