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The Bank of Canada said that its extraordinary efforts to soothe rattled financial markets are working, but it warned that credit downgrades and rising funding costs remain key threats to the corporate landscape – and the struggling energy sector in particular.

In its annual Financial System Review, the central bank said that 73 per cent of Canadian investment-grade debt is BBB-rated, which is just above speculative grade status. Sweeping credit-rating downgrades could swell the number of junk bonds, forcing companies to refinance at higher rates.

“The risk of credit downgrades is intensifying refinancing risks,” the Bank of Canada warned in its review, adding that the energy sector is particularly vulnerable.

“The energy sector has the most refinancing needs over the next six months ($6-billion) and faces the most potential downgrades. This sector’s ability to secure refinancing will be particularly tested with low oil prices,” the bank said.

The bank added that downgrades could also put new limits on the ability of energy companies to make financial and operational adjustments, further eroding the sector’s cash flow.

Soami Kohly, a fixed income portfolio manager at MFS Investment Management, said there has been record-high corporate bond issuance over the past month after the Bank of Canada stepped in to provide much-needed liquidity. The central bank last month expanded its bond-buying program to include the purchase of up to $10-billion of investment-grade corporate debt.

“The market is functioning after it was pretty much not functioning when everything was shut down in March,” Mr. Kohly said.

But, he added, yield spread levels over government of Canada bonds are much higher than they were in December, showing an elevated concern about risk by bond investors.

The Bank of Canada believes that credit downgrades could reverberate well beyond Canada’s energy sector and affect widely held fixed income mutual funds as well, which hold 23 per cent of all corporate bonds.

Even though the Bank of Canada said that its liquidity and bond-buying helped to calm financial markets, redemptions from bond funds totalled $14-billion in March, or 4.5 per cent of assets under management, as investors ran for the exits.

Although this total was considerably better than the central bank’s model simulation, which implied that redemptions could have hit $31-billion or 9.5 per cent of assets under management, the central bank warned that bond funds could be more vulnerable to another wave of redemptions, which can force funds to dump assets.

Fixed income funds have already used up part of their cash buffers to meet redemptions, and as a result the cash holdings of bond funds have fallen from an average of 4.2 per cent to just 3 per cent at the end of March.

“By rapidly rebuilding their cash buffers, they can help avoid future forced sales of assets that are less liquid,” the bank said.

However, the Bank of Canada noted that recent measures should help prevent some forced bond sales. Such measures include fund regulators providing more flexibility on how quickly funds must divest downgraded bonds, and postponing index rebalancing so that downgraded bonds are jettisoned from indexes at a slower pace.

Fitch Ratings, the credit rating agency, noted earlier this week that there have been 405 corporate and financial downgrades globally so far this year to the end of April, exceeding, in four months, the average annual total since 2002 and fast approaching the peak in 2009 of 747 downgrades during the financial crisis.

“Given the pace of downgrades since mid-March, we expect 2020 will represent a new peak level of annual downgrades,” Fitch said in a note.

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