Bountiful bonds

Corporate bonds might be suffering from their worst performance ever, but there’s a silver lining.

Today’s investors are compensated with a significant risk premium for investing in shortand mid-term corporate bonds (corporates) over similar term Canadian government bonds (Canadas). Yield spreads for corporates in Canada have moved sharply higher due to a number of factors:

• Investors are demanding higher liquidity premiums for owning securities other than the most liquid sovereign government bonds of developed countries; • Investors are commanding higher risk premiums for taking on additional default risk; and • A fear driven rally in Government of Canada bonds has pushed their yields to multidecade lows.

Looking back 15 years, shortand mid-term corporate bond spreads over Canadas have only recently multiplied exponentially, relative to their average from 1993 to 2006 (see “A Steep and Sudden Climb,” below).

Examining the period between 2003 and 2006, there was a fairly established range for yield spreads, with short-term spreads trading approximately in the 30 to 50 basis points range and mid-term spreads trading in the 50 to 75 basis points range over similar-term Canadas. Those numbers are now 328 basis points and 438 basis points, respectively (as of December 31, 2008) – literally, a five- to eightfold increase.

Previously, a spread-widening event from 50 to 100 basis points was considered cause for excitement. What investors are witnessing today is truly a oncein- a-generation phenomenon. The spread between Moody’s BBB-rated corporate debt versus U.S. Treasuries has not spiked to this extent since the Great Depression and currently yields an average of 600 basis points over Treasuries (see “Corporate Bond Yield Spread Versus U.S. Treasuries,” below).

WHY COPORATES? Investors are gun-shy due to the current credit carnage. As a result, we’ve seen corporates underperform Canadian federal government bonds by a staggering 11% on a year-over-year basis as of December 31, 2008. It’s the mother of all credit bear markets.

A look at the bigger picture shows why corporates are attractive as an asset class. A quarter century ago, corporate bonds consistently outperformed their Government of Canada counterparts. There have only been four to five instances in the past 20 years in which corporates have underperformed government bonds over the course of a calendar year. Even in those cases, corporates only underperformed their government-issued peers by a margin of 2% to 3%. And, these periods were followed by several subsequent years of strong overperformance. So, relative to equities or high-yield bond issues, investment-grade corporate bonds tend to be significantly less volatile (see “Corporates Versus Canadas,” below).

As markets continue to gyrate, high-quality corporate debt is being tarred with the same brush as debt securities that harbour greater risk. For example, five-year Royal Bank of Canada subordinated debt – rated AA by DBRS – is currently yielding approximately 420 basis points more than equivalent Canadas. During previous credit crises, such as the Long Term Capital Management hedge fund collapse in the late nineties, the spread over Canadas for a comparable Royal Bank issue widened to only 100 basis points.

Interestingly, even areas of relative safety saw risk premiums move significantly wider in the latter half of 2008. For example, 10-year Province of Ontario yield spreads over Canadas increased close to over 1.7% – exceeding historical spread levels. In this case, investors are being compensated primarily for an illiquidity premium rather than a default premium.

Liquidity risk is one reason for the all-time high spreads on corporate and provincial bonds. Investors’ continual selling of bonds to fund rebalancing of portfolios, of late, is another. The precipitous decline in global equity markets, generally, and the S&P/TSX in particular in the second half of 2008, has led to large volumes of bond sales as investors switched to equities in order to move back toward their strategic asset mix targets. This constant selling pressure has certainly been a contributor to wider spreads.

DO YOUR RESEARCH Going back to fundamentals, the probability of a default for Canadian financial institutions – large Canadian banks in particular – is relatively low. Investors have been rightfully wary of U.S. financial bonds. However, default risk has been significantly mitigated by the recent actions of U.S. policymakers. The nine major U.S. banks backed by the Fed’s recent $250 -billion capital injection appear to have unlimited support from federal authorities.

Notwithstanding governmental support for many of the world’s financial institutions, though, default rates on industrial corporate bonds, consumer loans, and real estate-related debt are likely to soar in 2009 and 2010.

To help mitigate this risk, your client’s emphasis should remain on quality securities, which necessitates extensive research and active monitoring of company fundamentals. While it would be false to say firms were not rattled by the credit crisis, there are industries and companies far better equipped to weather the storm, and the role of research is paramount in identifying worthwhile firms in these rapidly changing conditions.

ACTIVE MANAGEMENT The current environment provides fertile ground for active management. In a climate where outperformance – or alpha – is more elusive, prudent security selection is crucial. An active approach can help separate the wheat from the chaff. In the evaluation of corporate bonds, active managers employ a rigorous process that subjects a bond to industry, company and bondlevel analysis.

There are a number of factors to consider:

• A bond manager may need to investigate the trade-offs of investing in the debt of a company in a strong industry, but with mediocre management, against the debt of a company within a weaker industry that possesses good management. • Balance sheet analysis is also paramount as strong asset values provide additional insurance when examined together with free cash flow analysis. For example, a manager might look for companies possessing strong free cash flow, which is used to fund debt payments. • In addition to conducting a thorough credit analysis of each corporate issuer, a corporate bond manager must be diligent in analyzing the unique structural features associated with each bond (seniority, call risk, change-of-control protection). Understanding bond valuation from both a historical and global peer perspective is also essential.

BE PATIENT One important element of this strategy is patience. And it’s one you can’t stress enough with clients. For investors with the appropriate risk tolerance – and who who wish to capitalize on this unheralded credit dislocation event – a diversified bond portfolio that provides exposure across a variety of different asset classes, including corporate, provincial and high-yield bonds, is a prudent choice.

Given the opposing forces of extremely difficult economic conditions and historically cheap valuations, the correct approach is one of cautious opportunism. The pressure for spreads to remain wide persists as the process of broad-based deleveraging continues.

In coming months, as the credit cycle continues to evolve, the pain in the corporate bond market will likely shift from the financial sector to other areas of the market, including lowerquality industrial and real estate credits.

While an economic recovery may seem a distant prospect, one doesn’t need to rely solely on improving credit spreads to take advantage of this market. By focusing on quality corporate debt issues, bond managers can capitalize on historically wide yield spreads by collecting high-income streams and avoiding bankruptcies and other credit problems. An emphasis on good-quality credits allows a healthy yield advantage until such point as a narrowing of spreads creates capital gains. If, for example, high-quality corporates were to mature before a spread narrowing event occured, investors would still have collected a historically high yield premium along the way. The 300 to 400 basis points in additional yield over government bonds can generate a very attractive total return for a low risk investment. A narrowing of credit spreads would further enhance this return for the patient investor.

If, a year or two from now, there’s even a partial reversion of corporate spreads back toward their long-term average levels, the capital gains resulting from this narrowing of credit spreads, along with the attractive running yield, will result in superior riskadjusted returns for investors.

Hanif Mamdani is head of Alternative Investments at Phillips, Hager & North, Lead Manager of PH&N High Yield Bond Fund, and PH&N Absolute Return Fund. He is also a member of the firm’s Asset Mix Committee and Board of Directors.