Canadians investing in junk bonds are safer staying at home than venturing into the much bigger and more established U.S. market, a new report from one of the world’s leading bond-rating firms indicates.
Moody’s Investors Service reported Tuesday that Canada’s high-yield corporate bond market has tougher investor protections – known as covenants – built into its bond issues than the U.S. high-yield market.
And so-called domestic high-yield bonds (those issued in Canadian currency and targeted at Canadian investors) have stronger covenants than cross-border bonds (which are issued by Canadian companies in U.S. dollars and aimed at U.S. investors).
Moody’s based its conclusions on a rating system that rates each bond issue’s covenant package on the protection it gives investors against six key risks that can affect an issuer’s ability to pay back the money it has borrowed.
One risk is that the issuer may suffer cash leakage – by increasing its dividend payments to shareholders, for example.
Other potential dangers are the possibility that a company may invest in risky assets or increase its debt leverage.
Still other risks involve a bond’s subordination to liens, its subordination to new debt classes or how it will be treated if there is a change of control of the company.
High-yield bonds – also known as speculative-grade or junk bonds – were all but non-existent in Canada four years ago, but in the past two years the market has grown rapidly, generating nearly $30-billion in new issues, about one-third of which were in the domestic market.
Still, it’s a tiny market on a global scale. Of the roughly 1,000 global high-yield bonds issued in the past two years that are tracked by Moody’s, only about 30 came in Canada’s domestic market. The huge U.S. bond market has seen $3.3-trillion of speculative-grade issues in the past two years, dwarfing its northern neighbour.
Ed Sustar, vice-president and senior credit officer at Moody’s, cited the “nascent” quality of Canada’s high-yield market as a key factor in its superior investor protections relative to the U.S. market.
“It’s still such a new market; there’s not a lot of investors right now,” he said.
These investors – dominated by the big banks and a handful of large fund managers – hold enough power that they can convince debt issuers to sweeten the covenants in order to win their business.
“They’re able to push back on some of these deals,” he said. “It’s more of a negotiation.”
Mr. Sustar noted, however, that Canada’s high-yield covenant quality is inferior to the average scores in Asia, Europe and Latin America.
In particular, Canada lags behind these regions in protections against a borrower ramping up its leverage or making major new investments.
Among specific Canadian speculative-grade issues over the past two years, Postmedia Network Inc.’s $250-million issue of 8.25-per-cent, five-year notes generated the highest covenant-quality score, offering “strong protection against cash leakage and liens subordination,” the report said.
Two issues from MEG Energy Corp. offered the lowest covenant quality.
Mr. Sustar said the high-yield market in Canada has bloomed in the wake of the credit crisis, as a growing number of Canadian companies turned to the high-yield market as an alternative source of financing. But a big impetus has also come from investors’ demand for high-yielding products to replace the income-trust market, which was effectively eliminated by Canadian federal tax changes that took effect in 2011.
“When the income-trust market died off, that kind of morphed into the Canadian high-yield market,” he said. “People are getting more confident that this market is here to stay.”
The yields in the high-yield market have been highly attractive to investors, given the historically low yields on government bonds in recent years.
However, with central banks preparing to take action to stimulate the economy, and with the perceived risks in the European sovereign debt market easing in recent weeks, some of the premium has come out of high-risk bond yields.
The Financial Times reported Tuesday that the Barclays U.S. Corporate High-Yield index has dipped below 6.5 per cent, its lowest yield in the index’s 29-year history and down nearly two percentage points from the beginning of this year.