US high yield to withstand rate hikes despite short sellers

Fri Jul 26, 2013 10:50am EDT

* Short selling in US high yield companies picks up

* Rising rates will take a while to feed through

* Default rates are unlikely to spike immediately

By Natalie Harrison

LONDON, July 26 (IFR) - Short sellers may be targeting US high yield issuers in the equity market, but credit investors remain confident that most leveraged companies will be able to withstand an inevitable rise in funding costs and that defaults will remain low.

Demand to borrow shares of the 92 publicly traded constituent companies of the CDX North American High Yield index has risen to 5.8% of shares from an 18-month low of 5.5% at the end of June, according to data from index provider Markit.

The increase follows weeks of volatility since late May when Federal Reserve Chairman Ben Bernanke signalled the central bank would reduce its bond buying programme - sending the high yield credit index to a 2013 high of 478bp, and 10-year Treasury yields surging more than 70bp to over 2.7%.

"The increase in short selling may not be that spectacular, but it does indicate that people are beginning to question the impact on equity if the cost of financing for heavily indebted companies begins to rise," said Simon Colvin, an analyst at Markit.

AK Steel tops the most borrowed list, with 24.7% of its shares out on loan, while the cost of insuring its debt against default is the fourth highest in the Markit CDX North American High Yield index, according to Markit.

Competitor United States Steel Corporation also stands out, with 20% of its shares on loan as the industry continues to suffer from weak demand, while retailer RadioShack is second on the list with 22% of shares on loan.

That follows a surge in demand ahead of its earnings this week, which revealed worsening losses as its struggles against competition from online retailers, sending its 6.75% May 2019 bonds down USD4 to USD72 and its five-year CDS 90bp wider to 1,495bp.

CREDIT VS EQUITY

But some market participants say that the nascent pick-up in short selling may not necessarily be a bad thing, especially if the economic outlook is improving - a factor that the Fed says will drive its QE decision making process.

The CDX North American High Yield index has certainly recovered, trading around 378bp on Friday.

Chetan Modi, managing director at Moody's, said there were other variables to consider other than rising interest rates that could impact equity prices.

"If rates go up, yes the cost of funding will start to rise, but that will not impact the cost of fixed rate debt that is already in place," said Modi.

"It is mainly an issue for corporates when they have to go out to the market to refinance again."

US high yield volumes so far this year total USD246bn versus USD376bn for the whole of 2012, according to Thomson Reuters data.

Hermes Fund Managers, for example, is upbeat on US Steel's outlook from a credit perspective.

"We would actually take it as a positive that 20% of US Steel shares are out on loan. That means that bad news is being priced in," said Fraser Lundie, co-Head Hermes Credit.

"US Steel is in a very tough sector and it has had to behave defensively by cutting capex and cancelling future M&A plans. It has also undergone balance sheet repair, by paying down and terming out debt to protect its ratings and ensuring it has access to capital markets."

US Steel, rated Ba3/BB-/BB-, cut its dividend in late 2008, and has kept it low since then. It reported a first quarter loss at the end of April, and said it expected operating results to deteriorate further in the second quarter.

Its second quarter results will be released on July 30.

NO SPIKE IN DEFAULTS

Neither will defaults likely spike as a result of rising funding costs, both analysts and investors say, as companies have taken advantage of low rates to term out debt.

Global speculative-grade defaults rose marginally to 2.8% in the second quarter, but remain well below the historical average of around 5% and the spike in defaults seen in 2009 to around 12%, according to Moody's data.

"The fact that default rates have remained so low in one of the worst recessions in our lifetime doesn't suggest that we will see an immediate spike," said Modi.

"If interest costs do rise, this will be spread out over a period of time, and so there will be less immediate impact on cashflows."

US Steel, for example, refinanced existing debt in March with a USD275m 8NC4 senior note that was upsized from USD250m and paid a 6.875% coupon.

"Rising rates have not been an unknown risk. CEOs are not stupid, and have been clearly working with banks to get their capital structures in better shape," said Lundie.

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