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More weakness in high yield market negative sign for companies that need debt funding

2013.06.02 - HY IndexEnlarge Graph

  • Yields on corporate credit are important as higher yields mean higher borrowing costs (generally the same as interest costs) for companies, which lowers earnings.
  • The yield on the BofAML High Yield Index continued to increase on the week, ending at 5.93% on May 31st as compared to 5.60% a week earlier, but still down somewhat from ~6.20% at the beginning of 2013.
  • From a longer-term perspective, borrowing costs continue to be relatively low for companies across the credit spectrum.
  • High yield energy companies have tended to outspend cash flow, requiring them to turn to outside sources of capital, such as debt. The current state of debt capital markets have allowed these companies to raise money at cheap rates, benefiting earnings and valuation.

Corporate credit yields are a general term for the rate at which companies can issue debt (that is, borrow money). Higher corporate credit yields means 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, the yield on the BofA Merrill Lynch High Yield Index, the benchmark corporate credit index for non-investment grade companies (also known as high yield companies), increased from 5.60% on May 24th to 5.93% on May 31st, resulting in a negative for high yield companies needing debt funding. 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 at the top shows the yields on the BofAML U.S. High Yield Master II Index, which represents the universe of domestic high yield bonds. Despite the fact that credit yields have widened over the past three weeks, the yield on the HY Index is still down somewhat since the beginning of 2013, when it was trading at 6.20%.

As stated, yields have backed up somewhat, however, they remain relatively low, especially compared to where they were during the financial crisis. Companies can currently 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 firms that are planning to make an acquisition, or companies with bond maturities coming due that need to be refinanced (firms without enough cash on the balance sheet to simply pay the bond off).

It is impossible to know which companies will be making an acquisition, but for other fundraising needs, such as refinancing or funding cash flow gaps, it is possible to 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 this information was able to be found in the company’s recent 10-K. Recently, the company announced a $2.3 billion senior notes offering to tender for those notes amongst other issues, and it was able to issue the new bonds at relatively low rates of 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.

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). Confirming this, 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 which will be outspending cash flow and will need to raise debt to fill the cash flow gap.

In the short-term, the past week’s movement that has gone higher in rates was negative for high yield companies. In the medium-to-long term, the current and sustained low rate environment continues to be positive. 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. Note that many high yield energy companies are part of the Vanguard Energy ETF (VDE).