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What are we looking for?

A company with a non-investment grade rating likely to be upgraded.

The screen

The big ratings agencies – Standard & Poor’s, Fitch and Moody’s – give companies a rating on their debt, based on how creditworthy they perceive them to be. This rating has a tremendous impact on companies through its effect on their cost of capital. A company with an “AA” or “AAA” investment-grade rating will pay a much lower interest rate than a company with a junk bond-rating (or what is often now referred to euphemistically as “non-investment grade” or “high-yield”).

Furthermore, the biggest institutional investors such as pensions and asset managers are often restricted from holding non-investment grade-rated debt. This means that big waves of buying and selling (and therefore big changes in the market price of the bonds) occur when companies move between non-investment grade “BB+” and “BBB-," the lowest investment-grade rating.

If a bond investor knew which junk bonds were going to be upgraded, they could benefit greatly from these price moves. Stock investors would also benefit from the resulting lower cost of capital. The rating agencies are often criticized for being slow to react to developments in the market, though. For example, AIG and Lehman Brothers were rated “AAA” and “AA” respectively in 2008, and investment-grade ratings were maintained right up until Lehman Brothers declared bankruptcy and AIG had to be bailed out with billions of dollars of public money.

Refinitiv’s StarMine Credit Risk Model is an algorithm that provides a model-implied credit rating based on a company’s financial statements, as well as qualitative statements made by management and third-party news and research that is updated daily. On a historical basis, it has significantly outperformed the Altman-Z score – the classic test of credit strength – in predicting defaults.

Furthermore, when the model implied rating differs from the rating agencies’, those same agencies are four to five times more likely to move their rating toward StarMine’s than away from it. It is therefore a very useful tool for finding junk bonds likely to be upgraded to investment-grade status.

Today’s screen is very simple: Within the S&P/TSX Composite Index, we look for companies rated “BB+” – the highest rating for a junk bond – by S&P. Among these, we screen for those with a Refinitiv StarMine Model Implied Rating that is higher than “BB+” or, in other words, investment-grade quality.

More about Refinitiv

Refinitiv, formerly the financial and risk business of Thomson Reuters, is one of the world’s largest providers of financial markets data and infrastructure, serving more than 40,000 institutions in over 190 countries.

What we found

The screen yields five junk-rated companies, and two of them – Methanex Corp. and Russel Metals Inc. – have an “A-” StarMine Model Implied Rating, or in other words, less than a 0.08-per-cent chance of defaulting over the next year.

Vancouver-based Methanex is the world’s largest methanol producer with 15 per cent of global output. Methanol gasoline blends have been introduced in several countries, but their use is widespread in China and the company should benefit from increased Chinese demand.

Mississauga-based Russel Metals is also in vogue with Bay Street analysts. All research firms covering the stock (TD Securities, RBC Dominion Securities, Raymond James and GMP Securities) revised their fiscal-year 2018 earnings-per-share estimate upward in the past month. Also, Michael Tupholme from TD – the most accurate analyst covering Russel, according to StarMine – has the highest EPS estimate at $3.57, more than 10 per cent above the Street consensus.

Select S&P/TSX companies rated BB+ (highest rating for a junk bond)

Company Ticker Market Cap ($Mil) Recent Close ($) Stock's 1 Yr Rtrn. (%) S&P Debt Rating StarMine Model Implied Rating Implied Prob. of Default, 1 Yr (%)
Methanex Corp. MX-T 6,568.9 85.13 31.3 BB+ A- 0.07
Russel Metals Inc. RUS-T 1,582.1 25.16 -5.4 BB+ A- 0.07
Great Canadian Gaming GC-T 3,053.9 51.01 71.0 BB+ BBB 0.12
Cogeco Communications CCA-T 3,191.9 64.99 -24.6 BB+ BBB- 0.18
Teck Resources Ltd. TECK-B-T 15,733.7 27.52 0.1 BB+ BBB- 0.16

Source: Refinitv

Investors are strongly advised to do further research before investing in any of the securities shown here.

Hugh Smith, CFA, MBA, is an investment management specialist at Refinitiv.