Moody's has recently joined Standard & Poor's in downgrading Walter Energy (NASDAQOTH:WLTGQ), the troubled met coal miner that struggles from huge debt and low met coal pricing. Moody's downgraded Walter Energy's corporate family rating to Caa2 from Caa1, pushing it further into junk territory. The rationale presented by Moody's is similar to the one outlined by Standard & Poor's: low met coal prices lead to cash burn and difficulties with servicing existing debt. Walter Energy has been busy refinancing its existing debt, cutting costs and optimizing production levels, but it could need even more drastic measures to stay afloat.

Debt markets still open for Walter Energy
Walter Energy stated that the benchmark met coal price fell from $143 per ton in the first quarter to $120 per ton in the second quarter, making a 16% decline from already low levels. Despite this, Walter Energy was able to issue $320 million of 9.5% senior notes due 2019, intending to use $298.1 million to repay indebtedness outstanding under its revolving credit facility.

The fact that Walter Energy was able to get an interest rate under 10% is a big positive for the company. Walter Energy got the same rate in September 2013, when it was issuing $450 million of senior notes due 2019. The access to debt markets is crucial for Walter Energy, so the sole fact of successful debt issue is a step forward.

Back in May, Walter Energy's peer Alpha Natural Resources (NYSE:ANR) was able to issue $500 million of 7.50% second lien notes due 2020. Another coal miner, Arch Coal (NYSE:ACI), sold $350 million of 8% second lien notes due 2019 in December of 2013. Both Alpha Natural Resources' and Arch Coal's second lien notes received rates lower than Walter Energy' first lien notes, highlighting the fact that investors are very worried over Walter Energy financial condition. Thus, although the interest rate environment remains tough for most coal miners, it's especially tough for Walter Energy.

Importantly, the new debt issue increased Walter Energy's interest expenses once again. Interest expense weighs heavily on the company's performance. In the first quarter, Walter Energy spent $79.4 million on interest payments. It looks unlikely that Walter Energy could proceed with issuing more high-yield debt in the future, as it will put a heavy burden on its cash flows. However, there is an option to reduce indebtedness and interest payments.

Swapping debt for equity is possible
Walter Energy could choose to offer bond investors an option to swap debt for Walter Energy's shares. This move will reduce Walter Energy's debt and, perhaps most importantly in current situation, will reduce interest expense. Surely, this will dilute existing shareholders and pressure Walter Energy's shares. However, the company's future is at stake, and swapping debt for equity is a viable option.

When Standard & Poor's explained why it decided to downgrade Walter Energy at the end of June, it mentioned reduced production expectations as one of the reasons for the downgrade. Walter Energy decided to idle its Canadian operations back in April, and lowered its met coal production guidance to 9 million–10 million tons. Walter Energy's recent report showed that some of the risks materialized.

Difficult geological conditions at company's Mine No. 7 lowered production by almost 100,000 tons in the second quarter. Despite these challenges, Walter Energy still expects to meet its full-year production guidance. Walter Energy planned to sell more than it will produce this year due to the sell-off of Canadian inventories, so the sales numbers are more important.

Walter Energy reported preliminary met coal sales of 2.7 million tons in the second quarter. The company sold 2.6 million tons of met coal in the first quarter, so it is on track to reach the low end of its sales guidance of 10.5 million–11.5 million tons. However, it will be good for the company to accelerate the pace of inventories' sales in the second half of the year and reach the high end of sales guidance.

Bottom line
High interest expense burden could force Walter Energy to offer investors an option to swap debt for equity. While this will likely have a deteriorating effect on the company's share price in the short term, it will remove some of the interest expense burden. Hopefully, Walter Energy will give more clues on how it is going to deal with existing indebtedness when it reports its second quarter earnings.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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