U.S. Markets close in 4 hrs 33 mins

High yield rates finish lower week-over-week, for the first time in eight weeks

Ingrid Pan, Sr Energy Analyst

Corporate credit yields are indicative of the rate at which companies can borrow money

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.

(Read more: Introduction to the Permian Basin — Part 2: Geography of the Permian Basin)

Yields finished lower last week, for the first time in eight weeks

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) decreased from 6.84% on July 5 to 6.47% on July 12, resulting in a positive for high yield companies needing debt funding. This is the first time that the rate has decreased after eight consecutive weeks of increases. For much of the past two months, rates had been climbing at a rapid pace as the market worried about the Fed Reserve curtailing stimulus measures. However, last week rates retreated somewhat as the Fed had given signals that the labor market would have to further improve before stimulus measures would be cut.

(Read more: Introduction to the Permian Basin — Part 3: Major players)

The BofA Merrill Lynch High Yield Master Index is used as a gauge for where rates for high yield companies are trading

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. Recently, the yield on the BofAML HY Index had touched its highest point in 2013 after nearly two months of rates increasing. However, the yield on the Index has come down somewhat.

(Read more: Introduction to the Permian Basin — Part 1: Why is the Permian Basin important?)

Upstream independent energy companies often spend more than internally generated cash flow, and therefore must look to capital markets to raise funds

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 earlier this year. 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). Many upstream independent energy companies spend more than internally generated cash flow, especially those in high growth mode with significant expansion and development plans.

Companies where capex is likely to exceed internally generated cash flow (as determined by consensus estimates of EBITDA and stated capex guidance) include Oasis Petroleum (OAS), Laredo Petroleum (LPI), Chesapeake Energy (CHK), and SandRidge Energy (SD).

The movement lower in high yield rates last week was a short-term positive for high yield companies. However, prior to that the movement higher in high yield rates over the past eight weeks has been a medium-term negative. 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 two months 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 “Must-know: High yield fund flows regaining strength, time to dip back in?

More From Market Realist