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Canadian high-yield bonds offer more contractual protections for buyers than those in the U.S., but the defences are shrinking as interest in Canadian junk bonds rises.
A new report from Moody's Investors Service shows that the quality of covenants – limits on what a company that sells bonds can do – is generally stronger than those in the U.S. Such provisions include limits on dividends and other uses of cash, and caps on borrowing, all designed to protect creditors and ensure the company doesn't do anything that would unduly hurt their interest.
Canadian companies are not as well known, so they have to do more to draw investors. There are also fewer private-equity backed companies in Canada, and those companies tend to try to be more aggressive. On top of that, the market in Canada for high-yield bonds is still relatively small compared to the U.S. So investors in Canada have more ability to demand more protection than in the U.S., where deals often have so much demand that sellers can say take it or leave it, said author Ed Sustar of Moody's. The result is that bonds sold in Canada have tighter covenant packages.
"When you do a deal specifically in Canada, because it's a small investor base, those investors have the ability to push back on some of those covenants," said Mr. Sustar, who is a vice president and senior credit officer at Moody's.
Even so, Moody's found that covenant quality in bonds from Canadian issuers has weakened in the past 20 months. Some of that reflects more private equity backed deals, as well as an improvement in credit ratings. (Companies with higher credit ratings can get away with offering fewer protections because they are supposed to be in better shape.)
However, it also reflects growing demand that creates a dynamic a bit more like in the U.S.
"With the Canadian market getting bigger, you have more educated investors who are looking at these deals," Mr. Sustar said. "The deals are becoming more oversubscribed, so there's been greater supply of investors. A lot of the deals are becoming more take it or leave it. The structures are getting weaker and they don't have the ability to push back and get tighter covenants."
The Moody's system rates covenant packages from 1, at the strong end, to 5 at the weak end. The firm assesses what it calls six "key risks." They include restricted payments, debt incurrence, liens and structural subordination.
Canadian covenant quality slipped to 3.42 this year from 3.03 in 2012 and 2.96 in 2011.
That reflected deteriorating in five out of the six categories.
(Boyd Erman is a Globe and Mail Reporter & Streetwise Columnist.)
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