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London - Investors demanded higher yields to hold Tesco's debt on Friday while the cost of insuring against default rose sharply after ratings downgrades left Britain's biggest grocer hovering just above junk status.
Though Tesco does not face any short-term liquidity issues and has significant spare cash and undrawn bank facilities at its disposal, first-half interest costs amounted to almost 80% of its operating profit.
The group has lost more than 50% of its market value this year after an accounting scandal and a string of profit warnings that leave it facing multiple long-term challenges.
Its debt and pension deficit have also increased against a backdrop of wider structural changes within the grocery sector that have wrong-footed the once mighty operator.
As a result, all three credit ratings agencies warned that they could downgrade Tesco further, raising the spectre of a potential fall below investment grade, which would force many investors to sell.
"The ratings remain on review for downgrade because Tesco has not yet announced the outcome of its strategic review of the UK business and how it plans to tackle the longer-term challenges it faces," Moody's said.
Tesco said on Thursday that it was not comfortable with its gearing and was looking at ways to raise cash. It would favour the sale of assets and cost cuts before looking at a rights issue, it said.
Costlier debt insurance
On Friday its credit default swaps - derivatives used to insure against a debt default - widened by 20% and the spreads on its sterling bonds widened by 51 basis points against UK government bonds.
Tesco revealed last month that it had found a $402m hole in its first-half profit, sending shockwaves through the industry. It has since increased that to £263m and scrapped its full-year profit guidance.
A group of US investors, meanwhile, have brought a lawsuit against the company over the accounting scandal.
The former juggernaut of the retail sector has been battling fierce competition and rapid changes in the way Britons shop over the past few years. It is being squeezed by competition from discounters Aldi and Lidl at the lower end of the market and by Waitrose and Marks & Spencer at the top.
Tesco's net debt rose to £7.5bn at the end of the first-half of its 2014/15 financial year, from £7bn the previous year.
It paid £271m in interest during the period, against an operating profit that tumbled 78% year on year to £347m. Operating profit does not take account of interest payments.
While that shows the increasing pressures on the business, ratings agency Fitch said that Tesco had access to undrawn bank facilities of £2.7bn and a cash or cash equivalent balance of £2.9bn at the end of the first half.
Dividend cut
Both Moody's and Fitch said that previously announced measures, such as a 75% cut to the interim dividend and a reduction in capital expenditure to £2.1bn, also helped the retailer's short-term financial flexibility.
Analysts expect Tesco to take a similar cut to its final dividend at the end of the full year to enable the group to lower prices and increase staffing numbers.
Finance director Alan Stewart, in the job for only one month, told analysts on Thursday that Tesco had a strong funding profile and that his priority was to get the company in the right shape for the future.
"The redemptions we have in the next couple of years are relatively low in terms of our overall leverage," he said. "And that's a good position and it's a measure of the prudence with which the capital has been structured."
Tesco shares were also dented on Friday by a flurry of negative broker comments, finishing the day down 1.3 percent to give the group a market capitalisation of £13.7bn.
