CPPIB head raises red flags about low-quality bonds

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The head of the Canada Pension Plan Investment Board is sounding a note of concern as high demand for corporate debt has created lower-quality bonds that are riskier for investors in the event of an economic downturn.

Investors' desire for corporate debt – bonds companies issue to raise funds and that offer higher interest rates, or yield, than safer, government-issued securities – enables firms to determine for themselves whether the investors get paid first if it has to default, and to use a more liberal debt-to-earnings ratio to assess performance. These companies might not be able to issue debt under tougher standards.

“We’re very cautious on the loosening of credit,” says CPPIB chief executive Mark Machin, in describing the high demand for debt that has allowed this. “This deterioration of ... standards is something that could become a concern.”

McKinsey & Co. partner Susan Lund noted in a June article that since 2007, the amount of corporate bonds outstanding from non-financial companies has nearly tripled, to US$11.7-trillion, and their share of global GDP has doubled.

“The buildup in … corporate debt is a good example of a new risk that’s emerging in the financial system,” former Federal Reserve chair Janet Yellen said on Wednesday at the Bloomberg New Economy Forum in Singapore. Ms. Yellen said the United States has improved since the financial crisis in monitoring risks beyond the big banks, but “it’s unclear that we actually, at least in the United States, have appropriate tools to deal with these emerging risks.”

CPPIB can be hurt from this environment, or it could benefit by issuing high-yield debt itself to finance the purchase of companies. Reuters has reported the pension fund is part of a four-member consortium bidding to acquire aluminum products maker Arconic Inc., which has publicly traded stock and debt worth more than US$15-billion. Large acquisitions that require multiple big bidders – the partners are said to be Blackstone Group L.P., Carlyle Group L.P. and Onex Corp. – fell out of favour after the financial crisis. (Mr. Machin declined to comment on Friday about a potential Arconic transaction.)

CPPIB is not as worried if it is in that type of position in a deal, Mr. Machin says, but standards are “something we’ve been concerned about as buyers of debt,” and the CEO has had recent conversations recently on the topic with his head of credit.

He said that when CPPIB buys debt, it looks closely at the standards outlined in the debt documents companies issue with their bonds. “You have to get into the weeds in the terms of these loans," Mr. Machin said.

Mr. Machin’s comments came in an interview with The Globe and Mail upon Friday’s release of the fund’s financial results for its second quarter, ended Sept. 30. The CPPIB portfolio posted a 0.6-per-cent return for the quarter once fees and costs are removed, as a falling Canadian dollar was the main headwind, he said.

The portfolio recorded 10-year and five-year annualized returns of 9.1 per cent and 12.1 per cent, respectively, net of costs.

The plan’s net assets were $368.3-billion at Sept. 30, compared with $366.6-billion at June 30. The $1.7-billion increase in assets consisted of $2.3-billion in net income less $0.6-billion in net cash outflows for benefits.