Companies with funding needs could be hurt by rising rates

2013.02.26 - H0A0Enlarge GraphCorporate credit yields are a general term for the rate at which companies can issue debt (that is, borrow money). Higher corporate credit yields mean more expensive borrowing rates for companies, therefore higher yields are generally negative for companies, especially those with high funding needs which includes many upstream energy producers. Such needs might include expensive capital expenditure (spending and investment) programs, acquisitions, and refinancing of debt coming due. Inversely, lower yields benefit companies as they result in lower borrowing costs.

Last week, corporate credit yields in the high yield sector increased. High yield is a term used to classify companies with below a BBB rating from rating agencies such as Standard and Poor’s or Moody’s, therefore high yield companies are generally companies with worse credit quality (which could be due to a number of factors such as size, leverage, diversification, etc.).  One can monitor general corporate credit yields through an index such as the BofA Merrill Lynch Index, which aggregates data from many corporate bonds. The chart above shows the yields on the BofAML US High Yield Master II Index, which represents the universe of domestic high yield bonds.

For the week ending February 22, the yield on the BofAML High Yield Master II Index decreased slightly 6.08% to 6.07%. Given that there was almost no change in the yield, this was a neutral short-term indicator for non-investment grade companies

Yields on corporate bonds are currently low, especially compared to where they were during the financial crisis. In fact, companies can now borrow at close to or lower than pre-recession interest rates. A large factor behind this is the Federal Reserve’s quantitative easing program, which has pumped money into the financial system and caused investors to bid up the price of assets such as corporate bonds. Despite current low rates, investors should consider monitoring where corporate yields are, as a material move upward in borrowing rates could be a negative for companies. This is especially true for companies which will need to raise money in the debt market and may be forced to do so at higher rate if yields move upward. Companies with planned capital spending above cash flow, for instance, will need to source the cash shortfall somewhere and one option would be to issue bonds in the debt capital markets. Other companies that might need to access the debt markets include companies that are planning to make an acquisition, or companies with bond maturities coming due that need to be refinanced (and likely not enough cash on the balance sheet to simply pay the bond off).

It is impossible to know which companies will be making an acquisition. However, debt maturities are listed in company filings. For instance, Chesapeake Energy (CHK) has $1.4 billion of bonds due February 2015 which it must either refinance with new bonds, or pay off with cash or revolving credit facility.

Additionally, some companies may allude to the fact that they will be outspending cash flow. For instance, Range Resources in a December 2012 release regarding its capital spending plans noted, “Range currently plans to fund the 2013 capital budget from operating cash flow, proceeds from asset sales and its available liquidity under the Company’s bank credit facility.” This implies that the capital budget is greater than operating cash flow and outside cash is needed. While Range does not say directly that it will be looking to the bond markets for cash,  companies often issue debt if they have accumulated a significant balance on their credit facility (like a credit card for companies).

In the short-term, last week’s rate movements were neutral for high yield companies. In the medium-to-long term, the current and sustained low rate environment continues to be a positive for companies across the spectrum. However, despite the current favorable rate environment, investors may want to monitor rate movements, especially if they expect that the company will need access to the debt market in the near future.