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After two years of jaw-dropping debt issuance and never-ending demand for high-yield bonds, there’s one pressing question: Can the rally really continue?
The second-guessing doesn’t stem from irrational fear. There are some worrisome signs on the radar. Ten-year U.S. Treasury bond yields are rising after bottoming out at 1.39 per cent last year, and in January it looked as if investors were finally starting to dump bonds in favour of equities as the stock markets started to stabilize.
And in the high-yield market, there’s been such heavy demand that the benchmark index yield fell below 6 per cent, raising the question of whether investors are being adequately compensated for the risk they take when buying these bonds.
For now, though, these are simply signs to proceed with caution rather than a call to hit the panic button. After a rocky January, investors resumed piling their money into fixed-income funds in February. The Canadian market is popular with foreign issuers because the fixed-income investor appetite here remains so strong.
“I’m not freaking out and thinking it’s going to go radio silent,” said Sean St. John, co-head of fixed-income at National Bank Financial. Are there reasons to worry? Yes, he said. But Canadian investors still want bonds for the same reason they crave real estate investment trusts: They’re aren’t ready to give up on yield.
That’s good news for the international issuers who sell Maple bonds – debt issued by foreigners but in Canadian dollars. These securities were hot commodities in 2007, but their issuers retreated during the financial crisis. They’ve now returned with a vengeance, in large part because Canada has become “a much more global market,” said Greg Lawrence, managing director and head of investment grade credit at Bank of Nova Scotia’s securities unit. Last year Maple bonds raised $6.7-billion in Canada, driven by new infrastructure-related issuers.
The other hot market for new issuance is high-yield debt. Resource firms in particular have been shunned by shareholders because development costs keep soaring, and that’s put the likes of Eldorado Gold Corp. and New Gold Inc. in tough spots because they can’t afford to sit idly. To regain shareholders’ attention, they must grow, but they can’t do that without cash, forcing them to turn to the high-yield market.
Although this form of debt is expensive, “most of these companies are looking at 25-per-cent hurdle rates on their projects,” said Ross Prokopy, head of debt capital markets at GMP Securities, referring to the returns the miners expect from their developments. Even after they strip 6 or 7 per cent in coupon payments, “it’s still a pretty impressive return for them.”
High-yield debt is also becoming much less expensive. As investors flocked to this market to get their hands on decent returns over the past few years, high yields aren’t so high any more.
While that’s good for issuers, it’s been trouble for fund managers and investors. Halfway through 2012, Marret Asset Management cut the distribution on its High Yield Strategies fund because it could no longer pay investors the rate of return that they were promised.
Because some people worry the market is so overbought, investors have started withdrawing their money from high-yield funds. However, the debate rages.
Mr. Prokopy acknowledges that high yields are now low, but says their spread over government bonds isn’t anywhere near the historical records that would indicate investors aren’t thinking straight.
Mr. St. John, on the other hand, thinks the market’s primed for some kind of reversal.
“I think a lot of the stars are aligned and I would not be shocked if [high-yield bonds] repriced themselves,” he said.