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A broker talks on the phone in a trading room of a Portuguese bank in Lisbon, Thursday, July 10, 2014. Share prices on the Lisbon stock exchange fell more than 4 percent and Portugal's bond yields ticked higher amid growing concern about the health of one of the country's largest financial groups.

FRANCISCO SECO/AP

The Bank of Canada is warning that market turbulence could cause acute stress for people invested in high-yield Canadian corporate debt.

For years, central bankers have aimed to support the global economic recovery by nudging investors toward riskier asset classes via stimulative and unconventional monetary policy. In its June Financial System Review, the Governing Council pointed to ultra-low corporate bond spreads as evidence of this "search for yield."

But as the Bank of Canada and the Federal Reserve inch closer to rate hikes, which most analysts expect will occur around the middle of 2015, worries about the potential downside risks emanating from the continuation of accommodative policy have assumed increasing importance.

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December's edition of the Bank's biannual report on the state of the financial system notes that financial conditions for most companies have continued to ease. However, Canadian energy producers that lack high credit ratings are a notable exception – they've seen corporate spreads increase by 240 basis points since June, when the price of West Texas Intermediate was above $100 (U.S.) per barrel.

In the energy space, this increase in borrowing costs threatens to impair the ability of smaller, leveraged producers to continue to finance their operations. More generally, a rise in corporate spreads limits the appeal of borrowing money in order to buy back shares, which has been a driving force behind earnings growth during a recovery in which top-line growth has often proved to be elusive.

Even after the recent rise in corporate spreads against government bonds, which can be tied to tumbling energy prices, the Governing Council warns that "a potential deterioration of liquidity in Canadian corporate bond markets may not be fully priced in."

"Recent trends in asset prices could reflect investors' search for higher returns, possibly indicating that some investors have not fully taken into account potential credit downgrades, interest rate increases or possible difficulties unwinding their positions if future market conditions deteriorate," reads the Bank's report.

The value of non-financial corporate bonds outstanding rose to $203-billion in 2013 from $118-billion in 2006, according to the Bank, an increase of 70 per cent. Demand for these fixed income products has come increasingly from foreign investors along with mutual and exchange-traded funds. In the past, high-yield products were mostly held by insurance companies and pension funds, which took more of a buy-and-hold approach.

The changing composition of corporate bondholders is a boon to liquidity in normal times, says the bank, but could amplify the downside during periods of market stress by being net demanders, rather than providers, of liquidity.

"Market trends suggest that more sizable price swings might be observed in the future than previously, should investors seek to simultaneously unwind large positions," said the Governing Council.

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A report accompanying the release of the Financial System Review details how a rush to the exits in an exchange-traded fund could result in negative price dislocations. "ETFs are generally perceived as having equity-like liquidity; however, in times of stress, this liquidity may prove illusory for some funds," write Ian Foucher and Kyle Gray.

The spike in market volatility seen in mid-October, which the Bank chalks up to downgraded expectations for global growth and repositioning by some market participants, is a reminder of just how quickly sentiment can shift and runs on a given asset class can occur and reverse.

Meanwhile, the growing presence of foreign investors means economic shocks in other parts of the world will have a larger effect on Canadian corporate debt than ever before.

If foreigners begin to flee Canadian corporate bonds, domestic investors should take care to ensure they aren't the last ones standing at a party that has long since ended. Finding a dance partner may prove to be a challenging task.

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