Mind the hype — Tesla's $1.5 billion in new bonds are riskier than usual

Tesla Inc. has been shopping its first pure corporate bond offering this week, and a price at the levels whispered on Wall Street would be a big score for the Silicon Valley car maker.

Investors, however, may have to curb their enthusiasm: the bonds are lacking many of the customary bondholder protections for this much risk.

“Anyone who looks at a lot of high-yield bonds would expect more robust protection against future debt,” said Valerie Potenza, head of high-yield research at Xtract Research, a sister company of Debtwire. “We think it’s a terrible bond, but people seem blinded by the Tesla story.”

Tesla TSLA, -0.67% earlier this week said it plans to sell $1.5 billion in senior notes due 2025 to help shore up its balance sheet ahead of the Model 3 production ramp this fall.

A successful Model 3 production scale-up is the cornerstone of Tesla’s expansion plans, which include new passenger and commercial vehicles, solar-power products and the ability to produce cars at a rate of 500,000 by the end of 2018.

The bond offering is being whispered at a coupon of 5.25%, according to market sources, reflecting Wall Street’s continued strong appetite for riskier debt amid still-low interest rates on typically safer debt.

“Anyone who looks at a lot of high-yield bonds would expect more robust protection against future debt. We think it’s a terrible bond, but people seem blinded by the Tesla story.”
Valerie Potenza, head of high-yield research, Xtract Research

But Tesla faces “sizable near-term credit risks” associated with Model 3 production and sales, Moody’s Investors Service said in a note Thursday.

Moody’s assigned a B2 corporate family rating to the credit, placing it a full five notches into speculative, or “junk,” territory to reflect those risks. For Moody’s, that includes a “make-or-break” launch for Model 3, minimal proprietary technologies to keep Tesla’s competitive advantage, formidable competitors and credit metrics that reflect its junk credit profile.

Moreover, the deal is likely the first of many, according to analysts at CreditSights, which means competing debt in the pipeline that may entice investors.

High capital expenses and negative free cash flow “will be the reality” for Tesla for the foreseeable future. While Tesla holds an early-mover advantage in the electric-car space, barriers for electric vehicle penetration are still high, not to mention competition from rivals with bigger pockets and better distribution networks.

“We expect the deal will sell and perform well in a hot market, but we see 5.25% as inadequate compensation for the risks of the business and weak asset protection,” CreditSights analysts wrote in a note.

Tesla’s cash burn is another factor that might impact its ability to service its debt. The company had about $3 billion of cash at the end of June, but is expected to spend about $2 billion of that in the second half. Moody’s is expecting “significant” capex and cash burn through 2018.

“Debt service could become an issue depending on how much debt they sell,” said Xtract’s Potenza.

Then there’s the weaker structural protection Tesla is offering bondholders.

As a single B-rated credit, the Tesla notes might be expected to come with a full high-yield covenant package, a set of protections for the bondholder to guard the investment by preventing the company from using monies that could be assigned to interest payments for other purposes. The offering is lacking these protections.

“The covenants are weak,” said Potenza. “There are no restrictions on the company issuing further unsecured debt, on selling assets and on paying dividends or making investments. There is nothing to stop them from issuing notes on the same terms in an unlimited amount going forward.”

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Goldman Sachs Group GS, -1.60% will underwrite the deal. But the sole guarantor is Solar City, which Tesla acquired last year. And the notes rank behind $8.765 billion of debt backed by other non-guarantors, she said.

One major shortcoming in the covenants is the risky relationship with the company’s battery factory outside Reno, Nev., one of Tesla’s major assets. If the “gigafactory” were to issue its own secured debt, the holders of the Tesla-generated bond issue would be pushed even further down the capital structure, she said.

Finally, the notes don’t even have the call protection of an investment-grade bond, which means the company could refinance them at a lower level in a few years time.

Peter Schwab, senior vice president at sustainable asset manager Pax World and portfolio manager of the Pax High Yield Bond Fund, said the carve-out of the gigafactory was not expected and is part of the reason that high-yield investors are struggling to price the risk.

“But it’s a pretty compelling story and hard to ignore. Tesla from day one has proven the investment community mostly wrong,” he said.

Investors can take some comfort from Tesla’s enormous market cap, which currently totals $60.2 billion, according to FactSet. That makes it bigger than traditional car makers General Motors Co GM, -0.58% , with a market cap of $51.2 billion, and Ford Motor Co. F, -1.01% with a market cap of $43.1 billion.

“They clearly can access capital markets with an equity offering if they need more funds,” said Schwab.

Tesla’s most-active bonds, the 2.375% notes that mature in March of 2022, were last trading at a premium of 128.75 cents on the dollar, to yield 3.372%, according to MarketAxess. Those notes are convertible bonds, which means they can be converted into equity, and thus benefit from a rise in the underlying stock.

Tesla last week reported a narrower-than-expected second-quarter loss and bigger-than-expected sales, boosting its stock 6.5% on the week, its best weekly gain since April.

The shares have been on a tear this year, and are up nearly 68%. That contrasts with gains of around 9% for the S&P 500 index. SPX, -0.89% The stock last year lost 11% to the benchmark’s 9.5% gains.

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