McKinsey Global Institute published a report focusing on the total debt oustanding pre- and post- 2008 financial crisis.
Since the Great Recession, instead of de-risking and deleveraging globally, corporations have accrued more debt on their balance sheets and allowed their credit ratings to downgrade. Bond Capital believes that rising debt is related to quantitative easing by central banks around the world. Policy makers from major global economies have lowered borrowing rates to historic lows, which has attracted businesses to borrow cheaply.
What is the problem?
Standard & Poor’s (S&P) credit rating agency released a report earlier this year commenting on the decline in the financial health of global businesses. Highlights of the report include:
The greatest difference between positive and negative outlook (6% and 17% respectively) since 2008,
Average corporate ratings declined half a notch to between BB+ and BB (junk bonds), from those in 2008.
We remind readers that, under S&P’s definition, a bond is considered investment grade if its rating is BBB- or higher. As a result, credit availability or supply is now lower in most markets. At the same time, Bond Capital thinks demand will be at an all time high for senior debt.
In prior articles, Bond Capital has used US high yield benchmarks as a proxy for riskier private debt, but what about in Canada?
The yield on Canadian bonds continues to decline, and recent rate cuts by the Bank of Canada may cause them to stay low longer. Market speculation is that the US Federal Reserve may start raising interest rates in the fall, and we saw the beginning of this trend in the rise of high yield rates back in our spring article. As interest rates rise, the value of the bonds declines – which means that investing in US bonds may be less desirable than investing in markets where benchmark interest rates are steady or falling as they are in Canada today.
While Canada does not really have a high yield debt market, we do have a small, thinly traded market for convertible debentures. Convertible debentures are loans with the option to convert to equity at a predetermined share price (“strike price”). A convertible debenture’s value will mimic a company’s share price when the share price is trading above the strike price, otherwise it will trade like debt. Thus, to compare the Canadian convertible debenture market to the US high yield marketing, we stripped out convertible debentures trading like the underlying equity value (depicted below), to create a proxy for a Canadian high yield bond set.
Canadian proxy high yield is comparable to its US counterpart
While the yields on US and the Canadian proxy of high yield debt is similar, the spread over the respective government bonds is 1.1% higher in Canada. This will be the result of the smaller size of companies in the Canadian market, lack of liquidity in the market and due to the fact that these are convertible debentures which are more exotic. Canadian convertible debentures make for an interesting alternative if you are looking for yield.
High yield credit spreads are on the rise. Is this a trend or a blip? The current high yield index is still low when compared to the 15 year average of just under 10%. However, when looking at the 10 year decline in US bond yields over that same period, along with the recent uptick in high yield spreads, one has to wonder, what is going on?
With the prospect of ever declining treasury yields, and with negative interest rates a real possibility as shown in the chart below, it may be that investors will start to ask for increased credit risk spreads. This implies a decoupling of high yield rates with the lower reducing interest rates on offer from central banks.
While there are technical reasons for an investor to hold negative yielding investments over short periods, as a trade, a long term investor would choose to hold cash at 0% interest instead of incurring a cost to invest, or to make a riskier investment for an increased return. That this risk premium seems to be rising is interesting. At some point when the return is so low, it may not be worth the hassle of holding something risky for a small incremental return (compared to) earning no return at all.
As active investors in Western Canada we cannot help but pay close attention to energy prices. Over the last four months, oil prices have come off significantly and many investors are still grappling with the impact this will have on the Western Canadian economy.
Cheap oil would normally boost the US economy, but 30 year treasury yields are dropping too, which indicates the opposite.
Today, Bond Capital presents its research on high yield bond rates in comparison to the cost of mid-market Canadian Bank debt. In order to achieve the magnitude of leverage offered by the high yield bond market, Canadian senior bank debt is complemented with mezzanine capital for this comparison of finance options in the Canadian mid-market. US high yield bond rates were at 15 year lows in January 2014. Over the last 4 years, high yield rates range between 5.9% and 7.5% as shown in Chart 1 below. Bond Capital transactions are shown in Chart 2 wherein the cost of debt ranges between 4.2% and 6.9%. The Bond Capital transactions were between $100 and $250 million in enterprise value. The threshold for high yield bond issuance is estimated at greater than $200 million in enterprise value. The result illustrates that the Canadian mid-market bank debt markets are highly competitive with publicly traded high yield notes.
Further differences between high yield bonds and a made-in-Canada banking deal are summarized in the table below: