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Afraid of Dividend Cuts? Buy Bonds

By Roger S. Conrad on Dec. 18, 2014

With North American oil prices at their lowest levels since May 2009, energy producers have started to slash dividends and capital spending in response.

Of the 34 exploration and production companies that had unveiled their 2015 budgets, the 28 that announced reductions in capital expenditures cut their spending plans by an average of 19 percent. Odds are there’s a lot more to come.

High-cost producers in remote areas have been the first to take evasive actions. Canadian Oil Sands (TSX: COS, OTC: COSWF), which has operating expenses north of $45 a barrel, earlier this month announced a 43 percent cut to its quarterly dividend. The firm also slashed its capital spending to just CA$564 million, with CA$425 million allocated to facilities maintenance.

The stock has already lost more than half its value since later summer. Unfortunately, the new budget assumes that the price of West Texas Intermediate (WTI) crude oil will average $75 per barrel next year. If oil prices don’t recover, expect another painful dividend cut.

Over the next several months, dozens of producers—including many with far lower costs—will face a similar choice: Take on debt and hope for a comeback in crude-oil prices, or slash dividends and capital spending to prepare for the possibility of a prolonged slump.

Within out MLP Ratings and International Coverage Universe, 45 stocks yield more than 10 percent—a clear sign that the market anticipates more pain to come in the energy sector. And when the first upstream master limited partnership (MLP) cuts its distribution, you can expect the rest to sell off.

Given our intermediate-term outlook for crude oil and the threat of further dividend cuts, many of these stocks are cheap for a reason. Investors should regard any snapback rally as an opportunity to pare their exposure to these names.

Oil prices have caught a bid in recent days, while short covering has bolstered exploration and production company’s equity prices. Bond prices, on the other hand, tell a different story and suggest that fixed-income investors remain wary.

Investors looking for big yields and a larger margin of safety should consider bonds issued by junk-rated issuers that also have big dividend payout.

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