Rise in high yield rates slowed down last week, but still climbing
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- Yields on corporate credit are important as higher yields mean higher borrowing costs (generally the same as interest costs) for companies, which lower earnings. Many upstream energy companies outspend internally generated cash flow, requiring them to seek funds from outside sources such as the debt capital markets.
- The yield on the BofAML High Yield Index continued to spike up on the week, ending at 6.74% on June 28 as compared to 6.71% a week earlier. The yield is up over ~150 bps since early May, and during the week even spiked to levels above 7%.
- Given the recent rise and volatility in rates, companies may be reluctant to borrow money at the moment. This could put some cash hungry companies in a vulnerable position if they wait to borrow money, and rates continue to move higher.
Corporate 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, 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 6.71% on June 21 to 6.74% on June 28, resulting in a negative for high yield companies needing debt funding. This is the seventh week in a row that the rate has increased. For much of the past month and a half rates were climbing at a rapid pace. Despite that rates climbed this week, the increase was slight, and actually during much of the week, the yield on the index fell, as it had reached highs of 7% earlier in the week.
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 US High Yield Master II Index, which represents the universe of domestic high yield bonds. Now that credit yields have widened over the past seven weeks, the yield on the HY Index is at its highest point in 2013 and currently trading at the highest level since July 2012.
Investors should consider monitoring where corporate yields are, as a material move upward in borrowing rates is be a negative for companies, as has occurred over the past several weeks. 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, 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. 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 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.
The movement higher in over the past seven 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 rates continue to move upward. Given the possibility of sudden rate movements as had occurred over the past week and month, this is a factor that investors may wish to monitor, especially if they expect that 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”.