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Yields on corporate credit are important
“Corporate credit yields” is a general term for the rate at which companies can issue debt (that is, borrow money). Many upstream energy companies outspend internally generated cash flow, requiring them to seek funds from outside sources such as the debt capital markets. Higher corporate credit yields mean more expensive borrowing rates for companies, so higher yields are generally negative for companies—especially those with high funding needs, which includes many upstream energy producers. These 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.
Bank of America Merrill Lynch High Yield Index reaches yearly high
Last week, the yield on the Bank of America Merrill Lynch (BofAML) High Yield Index, the benchmark corporate credit index for non-investment grade companies (also known as high-yield companies), increased from 6.32% on June 14 to 6.71% on June 21, resulting in a negative for high-yield companies needing debt funding. This is the sixth week in a row that the rate has increased. The yield is up over 150 basis points since early May, and it’s at its highest point all year.
What is “high yield”?
“High yield” is used to classify companies with below a BBB rating from rating agencies such as Standard and Poor’s or Moody’s. So high-yield companies are generally companies with worse credit quality (which could be due to factors such as size, leverage, or diversification). You 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 U.S. High Yield Master II Index (HY Index), which represents the universe of domestic high-yield bonds. Since credit yields have widened over the past six weeks, the yield on the HY Index is at its highest point in 2013 and currently trading at the highest level since July 2012.
Why should you monitor high yield movements?
Investors should consider monitoring corporate yields because a material move upward in borrowing rates is negative for companies, as we’ve seen over the past several weeks. This is especially true for companies that will need to raise money in the debt market and that may be forced to do so at higher rates 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 plan 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’s impossible to know which companies will make an acquisition, but for other fundraising needs such as refinancing or funding cash flow gaps, you can make some predictions. For example, debt maturities are listed in company filings. Chesapeake Energy (CHK) had ~$464 million of 7.625% Senior Notes due 2013, which it needed to refinance, and you could find this information in the company’s recent 10-K (annual report). Recently, the company announced a $2.3 billion senior notes offering to tender for those notes among other issues, and it was able to issue the new bonds at relatively low rates: 3.25% for notes due in 2016, 5.375% for notes due in 2021, and 5.75% for notes due in 2023. The low interest rates on these new bonds are beneficial to CHK’s bottom line earnings and are also beneficial to other companies needing to refinance debt. Given the recent move upward in interest rates, if CHK had waited until now to refinance its debt, it likely would have gotten a worse rate.
Additionally, some companies may allude to the fact that they’ll outspend cash flow. For instance, Range Resources (RRC) 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 doesn’t say directly that it will be looking to the bond markets for cash, companies often issue debt if they’ve accumulated a significant balance on their credit facility (like a company credit card). Confirming this trend, in early March, Range Resources announced $750 million in new senior subordinated notes at a low rate of 5.0%—the lowest rate at which the company has ever issued senior subordinated notes. RRC stated that it would use proceeds to repay borrowings under its senior credit facility. The current low environment also benefits other companies that will outspend cash flow and need to raise debt to fill the cash flow gap.
Given the recent rise and volatility in rates, companies may be reluctant to borrow money, possibly leaving them in a vulnerable position
The movement higher over the past six weeks has been a medium-term negative for high-yield companies. Given the volatility in the debt markets, companies needing funding may choose not to tap the markets for money now. However, they could suffer if they wait and if rates continue to move upward. Given the possibility of sudden rate movements like we’ve seen over the past week and month, investors may wish to monitor this factor—especially if they expect a company will need access to the debt market in the near future. Note that many high-yield energy companies are part of the Vanguard Energy ETF (VDE). For more on high yield and debt markets, please see High yield bond flows take a U-turn and High yield issuance closes May with a nose-dive.
© 2013 Market Realist, Inc.