As central banks continue to pause, companies’ willingness to take on more debt has resulted in an influx of cash to the corporate bond market.
In the first quarter of this year, companies raised $14 billion in the Canadian bond market, compared to $7.9 billion in Q4 2018, the Globe and Mail reported based on Refinitiv data.
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Over the last decade, global outstanding corporate bond debt has doubled, hitting US$13 trillion at the end of 2018, according to the OECD.
“Investors took that pivot [to mean] that the Fed and central banks won’t tip the economy to recession,” says Geof Marshall, senior vice-president, portfolio management and head of credit for Signature Global Asset Management in Toronto. “So the market is now saying, ‘I’m confident lending money to corporates.’”
But as investors’ appetite for the corporate bond market increases, they should be wary of credit risk, says David Bradin, investment specialist at Capital Group in Los Angeles, Calif.
“I don’t think it’s a headwind this year, however,” he says. “The expectation is that defaults will remain below the historical 3% average.”
Still, investors should do a thorough analysis of a company’s financial statements.
“Leverage ratios, interest coverage ratios and asset quality are all things that our corporate debt team examines,” says Marty Balch, vice-president and senior portfolio manager, global fixed income and currencies at RBC Global Asset Management in Toronto.
Balch’s team is shifting the asset mix of high-yield portfolios towards higher-quality bonds and reducing duration to reduce credit risk exposure, he says. For instance, he’s reducing exposure to B-rated securities and adding BB-rated securities. “This is a move into a higher quality bond, but still high yield.”
Bond investors also face the risk that a company could be downgraded if its earnings deteriorate.
One way to mitigate this risk is to look at ratings agency reports on the company. “But the ratings agencies tend to be more rearview,” says Randall Malcolm, senior managing director at Sun Life Investment Management in Toronto.
Marshall agrees: “It’s not sufficient to rely on ratings by S&P and Moody’s.”
For instance, California-based utility company Pacific Gas & Electric, which filed for bankruptcy in January 2019 and could face billions in liabilities related to the state’s 2017-18 wildfires, was rated BA3 and BB- at the time it defaulted, notes Marshall.
Further, no matter what rating the agency has given, relying solely on credit ratings when evaluating a company isn’t enough because the bond can still default. Marshall says Moody’s mean annual issuer-weighted default rate for globally-rated companies from 1920 to 2018 is 1.01% for BBs, 3.14% for Bs, and 10.39% for CCCs.
“So it’s really [about] working with a manager who understands how to take apart a company, focus on cash flows, stress-test those cash flows under different economic environments, and who has a sense for how to price risk and knows how to build a diversified portfolio.”
Further, if a company is going through a takeover, ratings agencies often give the company “a bit of latitude,” warns Malcolm.
For instance, when retail pharmaceutical company CVS took over health insurer Aetna in November 2018, Malcolm says US$40 billion of debt was issued into the market. The companies took on excess leverage with a plan to reduce it over time, he says.
“The ratings agency will overlook this period of higher leverage,” he says, but those companies are more vulnerable to an economic downturn.
Instead of relying solely on ratings agencies when evaluating corporate debt, Malcolm suggests finding portfolio managers who do face-to-face meetings with the companies. “Talk about the challenges they see coming to their business.”
Investors looking for smaller spreads in corporate bonds should consider utility companies, says Malcolm. “Utilities didn’t widen out as much as the other sectors in Q4 2018,” when the market plummeted. “So it’s a safe sector.”
He suggests focusing on regulated Canadian utilities, like Alberta-based AltaLink. “You’re still able to earn a decent credit spread relative to provincial bonds.”
Balch likes Canadian investment-grade corporates with maturities of five years, which he says represent good value compared to government bonds. Specifically, he points to other regulated sectors—banks and telecoms. However, he’s holding off on further investments in the latter “as both Rogers and Shaw Communications are likely to have to come to market later this year to fund spectrum investments.”
Malcolm’s final tip for corporate bond investors: “Liquidity can change—your ability to get out of a position is dependent on the market. For investors looking at corporate bonds, you need a longer time horizon than an equity investor would.”
Corporate bond performance
The corporate bond market has performed very well this year, according to Marty Balch, vice-president and senior portfolio manager, global fixed income and currencies at RBC GAM.
As of mid-April, the high-yield market sector has returned 8.1% year to date, he says. That compares to 4.5% returns for U.S. investment-grade, 3.2% for Canadian investment-grade and 3.7% for European investment-grade.