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Why high yield rates continue to retreat, benefiting cash-hungry companies

Ingrid Pan, Sr Energy Analyst

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, including 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.

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

Yields finished lower again last week, erasing some of the steep rate increases through 2Q13

Last week, the yield on the Bank of America Merrill Lynch High Yield Index, the benchmark corporate credit index for non–investment-grade companies (also known as high yield companies) decreased from 6.47% on July 12 to 6.11% on July 19, resulting in a positive for high yield companies needing debt funding. This is the second time that the rate has decreased following eight consecutive weeks of increases. For much of 2Q13, rates had been climbing at a rapid pace, as the market worried about the Federal Reserve curtailing stimulus measures. However, over the past two weeks, rates retreated somewhat, as the Fed signaled that the labor market would have to further improve before it would cut stimulus measures.

The Bank of America Merrill Lynch High Yield Master Index gauges where rates for high yield companies are trading

“High yield” is a term that classifies 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 Bank of America Merrill Lynch (BofAML) 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. Recently, the yield on the BofAML HY Index touched its highest point in 2013 after nearly two months of rates increasing. However, the yield on the index has come down somewhat.

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 because a material move upward in borrowing rates is 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 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 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 whose capex (capital expenditure, the funds a company uses to upgrade its physical assets) is likely to exceed their 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: Introduction to the Permian Basin — Part 3: Major players)

Investors should monitor changes in high yield rates

The movement lower in high yield rates over the past two weeks 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. But they could suffer if they wait and rates continue to move upward. Given the possibility of sudden rate movements as 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?

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

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