U.S. Markets closed

Must-know: Borrowing costs for energy names continue to increase

Ingrid Pan, CFA

Corporate credit yields indicate the rate at which companies can borrow money

“Corporate credit yields” is 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. 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 because they result in lower borrowing costs.

(Read more: Crack Spread 101 (Part 1: What’s a crack spread?))

Yields finished slightly higher last week

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 6.36% on August 2 to 6.40% on August 9, resulting in a negative for high-yield companies needing debt funding. For much of 2Q13, rates had been climbing at a rapid pace, as the market worried about the Fed Reserve curtailing stimulus measures. However, during 3Q13, it seemed that the yield on the BofAML High Yield Index began to stabilize.

The BofA Merrill Lynch High Yield Master Index gauges 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. So high yield companies are generally companies with worse credit quality (which could be due to a number of 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, 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 decreased somewhat and stabilized.

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

Investors should consider monitoring where corporate yields are, because a material move upward in borrowing rates is a negative for companies, as we saw earlier this year. This is especially true for companies that 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 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 (capital expenditure) 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).

(Read more: Crack Spread 101 (Part 2: Factors that affect crack spreads))

Negative short- and medium-term outlook

The movement higher in high yield rates over the past two weeks was a short-term negative for high yield companies. Plus, though yields have retreated from 2013 highs, they climbed significantly through 2Q13, resulting in a medium-term negative. Given the possibility of sudden rate movements like we saw over 2Q13, 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 Why are high yield volumes strong despite fund outflows? (Part 1).

(Read more: Bakken crude begins to trade at premium to WTI, benefiting North Dakota names such as Whiting)

More From Market Realist