Oil-Rig Bonds Offer Yields Investors Dig

Mar 22, 2007 (From the Wall Street Journal via Dow Jones Newswires)

For investment manager Killik & Co., buying bonds that finance rig construction is a quirky way of profiting from the world's thirst for oil.

Investors such as Killik like these bonds because they yield more than conventional high-yield, or junk, bonds, yet their prices are more stable. Also, returns aren't correlated with the stock and bond markets, so they can be attractive to investors seeking solace from volatile markets.

"We wanted to get an attractive yield without taking on the same high risks associated with conventional high-yield bonds," said Mick Gilligan, director of fund research at Killik, which is based in London.

The market is small -- just over $4 billion in such unrated bonds were issued last year, compared with rated, global high-yield bond issuance of $222.89 billion, tallied by Dealogic, a data-tracking firm. Issuance so far this year is nearly $2.7 billion, according to Pareto Securities, a Norwegian brokerage firm. They have yet to attract the attention of big global banks that put together most of the high-yield bonds issued in Europe and are unknown among most investors, in part because individual issues tend to be less than $200 million. Their short track record means investors haven't been able to see how they behave during an economic cycle.

The bonds, often denominated in U.S. dollars, are generally issued by the Norwegian energy and shipping companies that dominate global rig-building capacity. They create publicly listed companies to finance and manage construction of new rigs and gear. They then leverage those companies by issuing debt tied to income from those rigs, which are deployed all over the world.

As oil producers step up exploration-and-production budgets to boost output and aging fleets are being replaced, demand for rigs -- and the bonds to fund their construction -- has grown. Pareto estimates roughly $7 billion of rig bonds exist with maturities up to seven years. Issuance, which more than doubled last year, is expected to increase again this year. The bonds aren't rated, but the implied rating, given the level of debt and risk involved, is a solidly speculative low B or high CCC. None have defaulted yet.

Like other infrastructure assets, these bonds are pitched to investors as offering stable returns. Long-term leasing contracts with big oil companies such as BP or Royal Dutch Shell allow rig owners to lock in revenue for years and can't be broken.

"With rig bonds, you are not taking a bet on the broader high-yield market, and we think that given the fundamentals in the oil space, our long-term view on the oil price and the infrastructure play, the cash flows to service and repay the debt are better underpinned than in traditional high-yield bonds," Killik's Mr. Gilligan said.

The bonds are also typically "secured," meaning their holders are the first or second creditors to be repaid if things go wrong; in some cases, the shipyard will issue a guarantee. Bondholders can take possession of the assets in event of a default and sell or operate them. These guarantees differentiate rig bonds from other high-yield bonds, which usually are unsecured, meaning they typically don't give bondholders the same guarantees that they will obtain the assets should the borrowers default.

"The rig-bond market . . . has a low correlation to international high-yield benchmarks," said Andreas Rode, high-yield salesman at Pareto Securities, which is based in Oslo and has been involved in about 75% of all rig bonds.

These bonds can yield as much as three percentage points more than conventional junk bonds, depending on the level of guarantee given. U.S. and European high-yield junk bonds on average yield slightly less than three percentage points above government bonds. The average yield on European and U.S. high-yield bonds was around 7.28% earlier this week, according to Merrill Lynch. This compares with a yield above 10% on the $250 million senior secured rig bond issued in February by PetroMena of Norway.

CQS Management, with about $6 billion of assets under management, raised GBP 50 million ($97 million) last year for a hedge fund that invests solely in rig bonds. CQS Rig Finance Fund, which trades on the London Stock Exchange's Alternative-Investment Market, closed at 103.50 pence ($2.01) yesterday. Shares were sold at 100 pence each.

"We believe rig bonds offer superior risk-reward than mainstream high-yield bonds or leveraged loans at the moment," said Mark Conway, head of credit trading at CQS and one of the fund's managers.

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