The decision on whether to hold corporate bonds – and how many to hold – depends upon the economic outlook. An economy growing at a good pace implies rising sales for issuers, more liquidity in the market and more corporate bond issuance. In weak or fragile economies, corporate sales will be stuck or will decline.
But all corporate bonds suffer together when stressed. Looking at the U.S. bond market performance at the end of the first week of December, when equities markets slumped, two investment-grade bonds dropped in price for every bond price that rose. The ratio in the high-yield market was a more moderate 1.4 declines for every gain, according to data from the U.S. Financial Industry Regulatory Authority.
That drop is not as severe as it was in 2008, when bondholders sold everything they could. “Top-quality was first to go because it was the easiest to sell, then junk followed,” says Timothy Hicks, vice president and portfolio manager with Canso Investment Counsel Ltd. in Richmond Hill, Ont.
However, although yield spreads for corporate bonds over government bonds have tightened, the premiums for the former group still are attractive. For example, a Government of Canada (GoC) 10-year bond with a 2.25% coupon due June 1, 2025, was recently priced to yield 1.89% to maturity. In comparison, a provincial British Columbia 2.85% bond due June 18, 2025, was recently priced to yield 2.59% to maturity, a 70 basis point (bps) difference.
Take on corporate risk and yields expand. A 10-year senior unsecured bond from shopping centre developer First Capital Realty Inc. with a 4.32% coupon due July 1, 2025, recently priced at $103.63, yields 3.90% to maturity – a 173-bps spread over the GoC bond for a solid asset with an investment-grade, BBB (high) rating from Toronto-based credit-rating agency DBRS Ltd.
Buying corporate debt requires more than usual selectivity, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto. “I would be looking at picking up higher-grade energy companies with lots of cash to cover interest payments,” Jong says, “so that even if energy prices go down, companies will be able to survive. I would not look for bargains in telcos because they are not influenced much by energy prices.”
Upstream oil producers will be pressured if oil prices stay low for another year, says Nauman Muzaffar, senior vice president, energy, with DBRS. Suncor Energy Inc., for example, which has an A (low) rating, can keep it for the foreseeable future, he adds.
But even with reduced expectations for cash flow, bonds from Canada’s large-cap oil producers – such as Cenovus Energy Inc., which DBRS rates at A (low); and Canadian Natural Resources Ltd., at BBB (high) – should hold their ratings, Muzaffar says.
Other resources sectors call for caution, given the downturn in commodity prices that’s been going on for three years. Bonds issued by companies with high debt/equity ratios and overextended capital commitments are particularly challenged.
Bonds with “negative trend” ratings from credit-rating agencies include bonds issued by Teck Resources Ltd. and Barrick Gold Corp. (both rated BBB with a negative trend), says Ernie Lalonde, senior vice president with the mining group at DBRS.
Falling oil prices are not critical for makers of heavy equipment used to extract oil. Gregory Pau, senior vice president with the industrial group at DBRS, notes that bonds issued by heavy-equipment dealer Finning International Inc. are rated A (low), while heavy-equipment dealer and pump maker Toromont Industries Ltd.’s bonds have a BBB (high) rating. Finning and Toromont both have a major income stream from maintenance work.
Bonds from Canadian National Railway Co. and Canadian Pacific Railway Co. are quality holdings, benefiting from the recovery of the North American economy, albeit suffering from the recent drop in oil prices.
Real estate investment trusts (REITs) tend to have stable ratings, having been financed at low interest rates, which means REITs can avoid refinancing if interest rates rise. One example is Brookfield Office Properties Inc.
In the merchandising business, Loblaw Cos. Ltd., Metro Inc. and Canadian Tire Corp. all are investment-grade. Food retailers benefit from food price inflation, and Canadian Tire has a niche in many of the small towns in which it operates.
High-yield bonds are problematic. Jong points to an AutoCanada Inc. 5.625% bond due May 25, 2021, rated B+ by Standard & Poor’s Financial Services LLC, recently priced at $99.50 with a yield to maturity of 5.715% – a reasonable risk for its spread over the GoC 3.25% bond due June 1, 2021, recently priced at $110.47 to yield 1.54% to maturity, he says. But beware: spreads widen when risks rise. The Merrill Lynch master II high yield index is paying almost 700 bps – 525 bps over U.S. treasuries. That premium has to cover a lot of worry.
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