Leverage Beckons as Punishment for Junk Status Loses BiteCharles Mead and David Holley
The way DigitalGlobe Inc. Chief Financial Officer Yancey Spruill sees it, credit investors are giving his company little reason to rush paying down debt that more than doubled after the satellite-imaging firm bought a competitor last year.
With the financial repression by central banks continuing for a sixth year, funding costs for speculative-grade borrowers such as DigitalGlobe are converging with those of higher-ranked issuers. That has left companies with the highest junk grade paying only 1.5 percentage points more, on average, than firms deemed investment-grade, about the slimmest margin since 2009 and down from a gap of 3 percentage points two years ago.
“I don’t know that reducing debt makes sense from a corporate finance perspective,” Spruill, whose company has $1.1 billion of total debt, said in a telephone interview. The company is ranked Ba3 at Moody’s Investors Service and BB at Standard & Poor’s. The BB tier is the highest junk level.
Monetary policy that Federal Reserve Bank of New York President William Dudley says will keep benchmark borrowing rates in check is leveling the field for the most indebted companies as investors seeking to boost returns buy riskier securities. That has opened the floodgates for junk issuers, with $1.58 trillion of high-yield bond sales since 2008 supporting a 74 percent expansion of that part of the U.S. debt market.
“As long as money’s cheap, there’s no incentive for a company to de-leverage,” Alan Cauberghs, the London-based investment director for fixed income at Schroders Plc, which oversees more than $400 billion, said yesterday in an interview in New York. “Companies can finance themselves at extremely attractive rates.”
Average yields on bonds in the BB tier due in five to seven years dropped to 4.94 percent yesterday, approaching the record-low 4.8 percent reached a year ago, according to Bank of America Merrill Lynch index data. Similar-maturity notes rated BBB pay 3.41 percent.
The market is encouraging companies to be “more aggressive with their balance sheets,” Morgan Stanley analysts led by Sivan Mahadevan wrote in a May 16 report. “The cost of moving down the credit ratings spectrum is not nearly as high as it once was.”
That doesn’t mean there will be a mass migration into junk as memories of the 2008 financial crisis are probably “still fresh,” the analysts wrote. Issuers in the BBB tier would have to boost leverage by more than a third to warrant a demotion to high yield, and in recent quarters the ratio of ratings increases to cuts have been “mostly above” the historical average of 1.7, they said.
DigitalGlobe, whose Tomnod.com website has tapped millions of people to scan through satellite images searching for clues about missing Malaysian Airlines Flight 370, issued $600 million of bonds in January 2013. The debt, which pays a 5.25 percent coupon, helped finance the company’s $800 million acquisition of GeoEye Inc. to create the world’s largest commercial-imagery satellite company.
The new bonds, which mature in 2021, plus a $550 million term loan helped lift debt to 4.5 times earnings on March 31 from a ratio of 2.3 at the end of 2012. The notes were valued at 98.9 cents on the dollar yesterday to yield 5.45 percent.
The broader high-yield market has been “extremely overvalued” for seven consecutive months, according to Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors LLC. An average yield of 3.77 percentage points above those on Treasuries compares with an estimated fair value of 5.7 percentage points, Fridson wrote in a report published by S&P’s Capital IQ Leveraged Commentary & Data.
“Monetary policy is the key to the present, extended period of overvaluation,” Fridson wrote. “Investors are accepting excessively small compensation for credit risk, so desperate are they to boost their yields.”
That desperation may not end quickly. New York Fed President Dudley said yesterday that the pace of eventual interest rate increases “will probably be relatively slow,” depending on the economy’s progress and how financial markets react.
The U.S. central bank is still injecting cash into the financial system by purchasing $45 billion of bonds per month, a pace that’s declined from $85 billion before it moved in December to start trimming purchases. The continued stimulus doesn’t risk sparking an undesirable jump in inflation, according to minutes released today of the Federal Open Market Committee’s meeting last month.
“With low risk-free yields and quantitative easing still the Fed’s operative policy, there will continue to be a global scramble for assets with yield,” said Edward Marrinan, a credit strategist at RBS Securities in Stamford, Connecticut. “The penalty for being downgraded in a compressed spread environment is much less than at other points in the economic cycle.”