It's silly season again in the corporate debt world, as markets continue to trade at less attractive levels than even the go-go, innocent days of early 2007.
Investors on both sides of the border are committing themselves to corporate bond issues with yields only marginally higher than risk-free government bonds, minimal upside but significant potential losses.
The Bank of America Merrill Lynch High Yield Bond Index tracks the average yield for the lowest quality, highest risk segment of the corporate debt market. The current average yield is only 3.64 per cent, 97 basis points above the 10-year U.S. Treasury bond yield. The 97 basis points above Treasuries is what investors receive in return for their willingness to accept credit or interest rate risk.
In February 2007, the high yield index was 120 basis points above the ten year. This means that current high-yield bond investors are more willing to take on risk than at the pre-crisis peak of the housing credit bubble.
Bank of America Merrill Lynch High Yield Index vs 10-year U.S. Treasury
SOURCE: Scott Barlow/Bloomberg
For John Jansen, who retired from bond trading after a 34 year career, the risks in the corporate sector now far outweigh the potential upside.
Noting that Colgate-Palmolive Co. recently issued five-year bonds yielding a scant 30 basis points above Treasuries, Mr. Jansen writes on his website, "Colgate is a solid credit but at +30 you are not receiving compensation for the risks which accompany ownership of a corporate bond. There is little chance that the spread will narrow and a reasonable probability that it will widen appreciably."
The Canadian corporate debt market is not immune from the buying frenzy. Manulife Financial Corp., like Colgate a strong, well-managed company, recently issued 10-year subordinated debt at 40 basis points above Government of Canada bonds.
It is highly unlikely that the spread will narrow from here – that the Manulife bond will trade with a yield even closer to government bonds – so the potential upside for investors in the issue is limited.
The Manulife bond is a "fixed floater" which means that it will maintain its current yield until the callable date, and after that the yield will rise and fall along with government bonds. But, if government bond yields rise before the issue's callable date bondholders could see a sharp reduction in the Manulife bond's value.
There's certainly no reason to blame Manulife, Colgate-Palmolive or any other debt issuer for coming to market when investor assets are so cheap to borrow – you would too in their place.
But for investors, the risk/reward scenario in the corporate bond sector seems prohibitively poor. Until conditions change, they are better off focusing on government bonds.