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Desire for yield whets appetite for junk bonds

If investment banks have it their way, Canada will soon have a robust high-yield debt market.

But Canada has some steps to take before it cranks out corporate bonds that pay high rates of interest, otherwise known as junk bonds. Investors need to ensure they understand the risks involved, and the country's bankers and lawyers need specialized education on how the securities are structured so there aren't questions or confusion when the market inevitably turns sour.

Unlike in the United States, where a healthy high-yield market exists, Canada's junk-bond market has never gotten off the ground. The last major push came about a decade ago but ultimately withered because income trusts paid lucrative yields underscored by much safer businesses.

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Now that trusts have been all but wiped out by tax law changes, investors are looking elsewhere for yield. The real thirst developed last summer when corporate bond interest rates hit rock-bottom levels, best exemplified by International Business Machine Corp.'s $1.5-billion (U.S.) issue at 1 per cent. In comparison, high-yield debt pays 7 to 9 per cent.

The new demand tempted riskier Canadian issuers (often rated double-B or B) that typically sell into the U.S. market to try their luck at home. Thirteen new Canadian offerings worth more than $3-billion hit the Canadian market in 2010. In almost every case, investors wanted to buy much more in junk bonds than the issuers were willing to sell.

With such lucrative business on the horizon, the investment banks are trying to lure high-yield specialists away from the United States to bolster their expertise. Until now, market-savvy institutional investors have been the big buyers and they're well aware of the risks. But it's only a matter of time before retail investors who yearn for the handsome returns trusts once provided try to get their hands on these bonds.

James Farley, senior counsel to McCarthy Tétrault and a former Ontario Supreme Court judge who specialized in restructuring and insolvency, has seen this excitement play out before. But the employee turnover on Bay Street worries him; people make their millions and then retire early, limiting any institutional memory.

"You have new people on the Street who are very bright," he said, but they "have not been through one or two downturns in the cycle and they think that everything is up."

His message: Some of this high-yield debt will default and investors will lose a chunk of their money, if not all of it. The economic outlook may look rosy right now, but what happens to these already-risky issuers during the next downtown? Even worse, historical research proves that high-yield debt isn't simply at the mercy of the economy and these bonds follow their own cycle.

Ed Altman of New York University's Stern School of Business is an expert on high-yield products. His research has proven that high-yield default rates always rise 18 to 24 months after periods of increased issuance. The evidence is so strong that the correlation is practically 100 per cent.

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Mr. Farley has heard similar stats himself. Just last week, he was at a symposium where some staggering default rates were cited. Debt with a 'B' rating has a 50-per-cent chance of defaulting in 10 years, and anything with a 'C' rating has a 70-per-cent chance of defaulting over the same period.

Not only that, the companies that issue high-yield debt don't always own hard assets. If these firms go belly up, the bondholders may have nothing to salvage to stem their losses. That's worth noting, now that investment banks are out pitching junior mining companies on issuing high-yield debt because these firms often have few proven resources.

How can a potential debt crisis be averted? Education. Lawyer D'Arcy Nordick at Stikeman Elliot worked on about half of the 2010 issues, so he knows first hand that high-yield products are structured differently than investment-grade bonds. "There's definitely a learning curve," he said.

For instance, high-yield debt has additional financial covenants to protect investors. Examples include "incurrence tests" that prevent the issuing companies from going out and incurring debt above a certain limit and from making unnecessary payments that drain cash flow.

Moreover, unlike bank debt, high-yield covenants are much harder to alter if the company suddenly needs financial flexibility. For a bank facility, the company can simply make a request to the lead lender, but for a public issue a noteholder meeting is mandatory.

Some firms are being proactive. Stikeman Elliot is putting together a summary document on high-yield debt to distribute to all its lawyers. But Mr. Nordick stresses there is no reason to worry that high-yield debt could become the next ABCP, debt based on pools of underlying assets like mortgages that seized up during the financial crisis.

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"Unlike asset-backed commercial paper, where it was a complicated structure, complicated clauses … you're looking at real businesses. How they operate Cash flows. Income," he said. Plus, high-yield debt isn't rated triple-A like ABCP was.

That hasn't stopped other companies from going all-out on the education front. Last year, Catalyst Capital, Canada's leading distressed-debt investor that was behind the Quebecor and Canwest restructurings, organized a conference at University of Toronto where high-yield guru Ed Altman was the guest speaker. The effort was spearheaded by the firm's managing partner, Newton Glassman, who is calling for more sophistication north of the border.

His interest is obvious. The better educated Canadians are about junk bonds, the easier it is to go through the restructuring processes from which he makes his living, and he admits that. But he also worries about the systemic risk for the good of the average investor. Without a sophisticated market, "who's going to come in and clean up [the debt]when the company is in trouble?" he asks.

Mr. Glassman said the first test of whether or not Canada is up to speed could come in 2011 and 2012. During the financial crisis, "there was an enormous amount of debt that was 'amended and pretended,'" he said, meaning that a lot of troubled debt was given some breathing room and will soon have to be refinanced.

Some argue that Canada needs strict restructuring and distressed-debt rules to make the market much more predictable. Critics of the current system point to cases like the Supreme Court decision that backed the private equity buyout of BCE, even though the deal was ultimately shut down by an independent review that said the company was taking on too much debt.

Mr. Farley isn't so certain that strict rules are necessary. "I'm an old common law judge... and I think you've got to have enough flexibility to give the court the discretion to come up with the reasonable and sensible, fair and equitable resolution," he said.

Yet even if rules are created, lawyers will need years to draft them. In the meantime, Catalyst's Mr. Glassman said investors shouldn't fear high-yield debt.

A high default rate "doesn't mean it's a bad asset class to be in, and it doesn't even mean that your returns will be unnecessarily punished," he said. "It means you have to buy it at the right price and you have to buy a diversified portfolio."

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