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Accessing Leveraged Capital Markets – Part II

Getting a Credit Rating for High Yield Bonds

When debt issuers want to issue debt in a public offering1, they will need credit ratings from the three major credit rating agencies: Moody’s, S&P and Fitch Ratings.

Generally, investors like to see at least two, with Moody’s being the gold standard when it comes to credit ratings. Accordingly, it is common to see Moody’s/Fitch or Moody’s/S&P with ratings such as Ba2 and BB+.

Moody’s is generally seen to be conservative and with a visible quantitative scorecard – although of course they leave room for interpretation for qualitative variables and will adjust accordingly.

Rating agencies will have thoughts on liquidity (cash and bank revolver capacity available), leverage, interest coverage and a host of other metrics that are relevant to the sector the credit is classified in (materials, real estate, oil and gas exploration).

The rating agencies will generally rate both the issuer as an independent entity as well as a specific tranche of debt. For instance, Company A may have secured notes which have certain assets pledged as collateral where they have a first lien. They may also have a general corporate rating. The secured notes may be rated AA- while the issuer may have an A rating.

Depending on how much debt investors trust the rating agencies, this can make or break a deal as it flows through to investor demand. Some high yield mutual funds or index ETFs have specific mandates for BB or B rated debt, so if the rating desired is not achieved, a deal can be pulled. If the issuer or a contemplated offering is rated with any C handle, the debt is generally seen as distressed and may have difficulties accessing markets at attractive terms.

Full service investment banks with strong leveraged finance platforms will generally have ratings advisory arms that will have a general idea of where the hypothetical or contemplated bonds or term loans will be rated at given their professional judgment and market intelligence. Potential issuers will work closely with these experts and the leveraged finance product at the investment bank to prepare for conversations with rating agency analysts.

Pricing High Yield Bonds

As with most other thought exercises involving investment banks, pricing bonds requires comparable company analysis/using a comp set. Obviously the best comp for a company is itself.

If a bond issuer already has existing bonds outstanding, the contemplated issue should fit somewhere around where current bonds are trading in terms of their yield to worst (YTW). The more data points the better because that is already a realistic assessment of what the investor market rates their bonds in terms of required return – so a company with a built out credit curve (spaced out maturities of pari passu debt) can have a reasonable assessment of the indicative new cost of debt.

A straight refinancing is very straight forward as the credit profile/leverage of the issuing firm does not change, while maturities are kicked out. This is probably the simplest exercise. Incremental debt that does not move the leverage needle as the firm grows is also straightforward. When there is a larger issuance that may impact the credit, this is where more guesswork has to be done. A maiden issue would likewise require more educated guesswork.

So far, we have only been considering vanilla cash coupon bonds that are pari passu (have the same seniority as other debt outstanding). If certain bonds are granted 1L (first lien) on certain collateral, they should in theory have a lower yield (price tighter) because it is more safe. If 2L notes are issued (whereby they have a subordinated claim on collateral) they should price wider than the senior debt.

Public or Private Debt

One of many decisions that corporates make is whether to go down a broadly distributed or privately marketed route. Big bond issuances with routine refinancings are associated with broadly distributed offerings where a very large subset of high yield bond investors are contacted.

The terms of the bond indenture/bond contract are market standard and there should generally be no surprises while the yield that the bond prices at should be in line with market. Covenants are standard, events of default are standard, change of control provisions are standard, call provisions are standard.

Private debt deals are done with a much smaller group of investors and tend to be more bespoke – what this means is that the deals can be non-standard. In this more structured process, the debt investors become more intimately familiar with the credit and can give up yield for tighter covenants or vice versa, amongst a variety of other credit enhancements or reductions.

Private debt can be attractive both for creditworthy companies and very uncreditworthy companies.

The Risk-Free Rate and the Credit Curve

Investment grade bonds have a different investor base that does not necessarily have default front of mind for corporate debt. An investor looking at Microsoft or Salesforce bonds is simply going to look at the yield for the maturities relative to a benchmark risk free security (a similar maturity US Treasury Bond or UST). If the reference Treasury bond yield rises, expect the corporate yield to rise in tandem.

The further down the credit curve an investor goes, the more the yield is influenced by firm specific factors than macroeconomic factors (although they are still related). As such, when yields rise, you sometimes will see the credit spread tighten (the spread between the credit versus the risk free yield) as the acceptable return for holding a credit stays the same.

Any bonds that have a C handle (rating of Caa/CCC+ or below) are considered distressed securities and from there it becomes very much a idiosyncratic credit story. The benchmark yields will have a much more limited bearing on these credits. Also, while BB and B bonds tend to track their respective indices, C bonds price all over the place as investors are much more closely following the individual credit.

Credit rating agencies are much slower than bond investors in adjusting ratings, so you may see yield widen materially before corrective action is taken by the agencies.

  1. Generally through a broadly distributed marketing effort with debt investors acting primarily on public information and are not wall crossed – referring to the Chinese Wall in finance – or privy to non-public information
Fixed IncomeChina Stocks Investing: New Cold War and Bond Defaults · Distressed Debt Overview · Spreading Investment Banking Comps: Net Debt · High Yield Bond Characteristics · Introduction to Green Bonds · Understanding the Yield Curve · Distressed Debt Interview Questions · Interview with: Private Debt Analyst · Interview with: Credit Rating Agency Analyst · Fixed Income Analyst Interview Questions · Collateralized Bond Obligation (CBO) and Collateralized Loan Obligation (CLO) and Collateralized Debt Obligation Trusts (CDO) ·
Leveraged FinanceOverview of the Leveraged Finance business · Leveraged Finance Debt Capital Markets in Asia · CLOs at the Center of the New PE Industry · Incurrence Covenants for High Yield Bonds · Accessing Leveraged Capital Markets – Part I · High Yield Bond Characteristics · What Makes a Good Leveraged Buyout (LBO) Candidate? · What is a Leveraged Buyout? Introduction to LBOs · Introduction to High Yield Bonds · Interview with: Private Debt Analyst · Options for Distressed Debtors: Refinancing and Restructuring · Differences Between Leveraged Finance and DCM · Debt Refinancing Options for Issuers ·
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