Historically low LIBOR rates are driving yield hungry fixed income investors into the high yield debt market on an unprecedented scale. Australian resources companies have been taking advantage of this, with Fortescue Metals alone undertaking six high yield bond issues in the last two years. However, the story is different for most of the rest of sub investment grade corporate Australia, with high cross currency swap costs remaining a significant impediment to the broader development of this market.
Resource sector issuance
US high yield bond issuance from the Australian resources sector has experienced a resurgence in the past two years with issues from Fortescue Metals, Mirabella Nickel, Midwest Vanadium, Consolidated Minerals, Aurora Energy and Linc Energy.
Factors driving the market include:
- historically low LIBOR rates - which in addition to providing a low pricing benchmark have driven unprecedented inflows into high yield debt funds;
- strong investor appetite for resource sector credit as an inflation hedge and a proxy for access to the Asian growth story;
- declining liquidity in the A$ bank debt market driven by a combination of foreign bank withdrawals and the impact of Basel III;
- the absence of an Australian domestic sub investment grade capital markets option; and
- the increased flexibility that incurrence covenants offer commodity price exposed resource sector issuers when compared with maintenance covenants that are typical for bank facilities.
In addition, these resource sector issuers all share the important characteristic of significant US$ revenues against which US$ denominated debt provides a natural hedge.
These same factors are also driving Australian resources companies, such as Fortescue Metals and Atlas Iron, to raise debt in the US$ term loan B market. Term loan B facilities, sometimes referred to as “covenant-lite”, offer borrowers the flexibility of incurrence covenants found in high yield bonds but in a floating rate format with greater prepayment flexibility than a fixed rate high yield bond.
Incurrence vs maintenance covenants
High yield bonds and term loan B facilities feature incurrence based financial covenants which are tested only at the time the borrower wishes to incur additional debt or make distributions. In contrast, typical bank debt maintenance covenants are tested periodically (quarterly or semi annually), with a breach of covenant triggering an event of default and giving financiers the right to accelerate repayment.
For issuers with revenues exposed to commodity price fluctuation (which impacts EDITDA and in turn the borrower’s interest cover ratio) the additional flexibility that incurrence covenants afford during a commodity price downturn is particularly valuable. For example, when iron ore prices fell sharply last year and concerns were raised about Fortescue’s ongoing covenant compliance, Fortescue responded by refinancing its entire bank debt exposure with a US$4.5b secured term loan B facility which contains incurrence covenants only.
The Fortescue experience has put the benefits of incurrence covenants over bank debt maintenance covenants firmly on the radar of Australian resources sector executives and will be a key factor favouring debt raisings in the high yield and term loan B markets going forward.
Australian corporate sector issuance
The fundamental issue for the broader Australian sub investment grade corporate sector is that neither the Reg S/Rule 144A high yield bond market nor the term loan B market lends in Australian dollars. As a result, corporates that do not have the natural hedge of US$ revenues must swap the borrowings back into Australian dollars. While this is also true for investment grade borrowers that issue US$ denominated bonds such as Telstra, Wesfarmers etc, such credits have greater access to swap lines and the credit charges associated with their cross currency swaps are significantly less than those for sub investment grade credits. This disparity is also set to widen further with the introduction of the Basel III credit valuation adjustment (CVA) charges for derivative transactions.
Despite the best efforts of investment bankers pursuing a high yield solution for Australian corporate leverage and financial sponsor buyout transactions, this cross currency hurdle has to date proved too high, with Australian corporate issuance being limited to borrowers with significant US$ revenues – eg. Nufarm’s US$325m Senior Notes, Ausdrill’s US$300m 6.875% Senior Notes and Bluescope’s aborted US$300m note issue.
One exception is Nine Entertainment’s recently announced US$700m term loan B facility. While the history of this credit in the Australian bank debt market may have been an additional factor favouring borrowing from a new market, the transaction has shown that for the right credit, in the right circumstances, the economics of a high yield bond or term loan B facility may stack up notwithstanding the absence of US$ revenues.
The economics may well be more compelling for borrowers that place significant value on the additional flexibility that incurrence covenants provide. While offshore experience shows that the international financial sponsors do place such a value on incurrence covenants, it remains to be seen whether the swap costs economics can stack up for an Australian leveraged buyout transaction where leverage levels typically dictate credit metrics in the single ‘B’ range rather than the ‘BB’ rating of the Nine Entertainment facility.
Where to from here?
European issues and tighter global banking regulation will continue to restrict liquidity in the Australian bank debt market for the foreseeable future. This will continue to encourage Australian borrowers, both investment and sub investment grade, to increase the proportion of capital markets debt in their capital structures.
While LIBOR rates remain low and inflows into the high yield market remain high, we expect the trend of high yield issuance from the Australian resources sector to continue and some increase in the number of Australian corporates, particularly those with US$ revenues, accessing the high yield markets.