Central banks’ efforts to shore up liquidity in bond markets by purchasing billions of dollars worth of government and investment-grade corporate debt have forced financial advisors and investors who want yield to shop downmarket and focus on bonds rated below investment grade. In effect, they have to accept more risk for more yield in a market still reeling from the credit crisis that hit in March.
Geof Marshall, senior vice-president, portfolio management and head of fixed income at Signature Global Asset Management, a division of CI Investments Inc. in Toronto, points to a Parkland Fuel Corp. 6 per cent bond due Jan. 21, 2027, which is rated BB (“speculative, faces major future uncertainties”), as an example of this trend.
On March 20, just as the Bank of Canada’s plans to purchase government debt were announced, the Parkland bond was priced at $92.39 to yield 8 per cent to maturity. At the end of May, the bond traded at $100.25 to yield 6.43 per cent to maturity as a result of the bond-buying program and greater confidence among investors. What’s significant is that with more money in this tier of debt, trades are a lot easier. More liquidity in the non-investment-grade space means there’s less trading risk.
“It’s a huge change from mid-March when a lot of corporate debt was bid-free,” says Mr. Marshall, who holds $30-billion of bonds in the investment funds he manages.
Thanks to central banks’ intervention, the bond market is trading actively again. The significant amount of money pouring into corporate bonds on either side of the U.S.-Canada border invigorated the investment-grade corporate bond market, Mr. Marshall says. The recovery of the corporate bond market has sent a message – with more money available, companies can refinance more easily.
For investors, the irony that central banks would support debt with little or no default risk means yield-seeking investors have to shop in the junk bonds’ space for yield, says Chris Kresic, head of fixed income and asset allocation and portfolio manager, fixed income, at Jarislowsky Fraser Ltd. in Toronto. “It’s a domino effect. I used to be able to get a sufficient return on BBB-rated bonds. Now I have to shop BB-rated bonds.”
The consequence of being shoehorned into BB-rated space is that investors take on more default risk. But some of that risk is illusory. Good bonds can wind up with crummy ratings in this turbulent market.
At the high end of the non-investment-grade market are fallen angels. A Kraft Heinz Co. 10-year bond issued Sept. 11, 2019 and due April 1, 2030 with a 3.75 per cent coupon was originally rated BBB-, the lowest rung on the investment-grade ladder. Then, it dropped to BB+, just under the investment-grade threshold or the highest level in the junk bonds space on Feb. 14.
“This [bond] is a fallen angel, but it’s really backed by a financially strong company,” says Nicholas Leach, vice-president, global fixed income, and head of high yield at CIBC Asset Management Inc. in Toronto. ”Kraft Heinz’s management had the choice of paying its dividends or slashing them to zero. But Kraft Heinz did not cut or cancel its dividend to conserve cash. Instead, it chose to have less bond interest coverage and its debt became high yield.”
Some investors and investment funds cannot hold non-investment grade debt. And when the Kraft Heinz issue lost its investment-grade rating in February, investors restricted by preference or mandate to investment grade were forced to sell the issue when it fell into junk territory.
The resultant drop in the bond’s price from US$105 TO US$88 in early March, driven by the market selloff, saw the yield to maturity rise from 3.6 per cent to 5.3 per cent. Anyone who bought at that time got a good deal. Buyers wound up with a well-backed bond that might have been passed by if central banks’ bond rescue programs had not promised to buy up investment grade corporate debt. That plan gave good subinvestment grade debt a lot more respect.
“The central banks were pushing investors down the credit curve into an asset category, junk, that many previously would have rejected as out of their comfort zone,” Mr. Leach says.
“Government supports for the bond market were unprecedented in amounts committed, types of bonds supported, and a push on investors to go where many had not gone before,” he adds. “Governments will continue to support credit markets in these dark times. As long as markets are under pressure, government programs will tend to make subinvestment grade bonds more attractive than they would be without government supports. When government support programs end as the economy improves, it will be for good reason and to the benefit of corporate bonds bought in hard times.”