Times are good if you are a borrower, with dropping yields, favourable terms and abundant capital. But as the team at leading Canadian institutional investment management firm Canso Investment Counsel wrote in their latest Corporate Bond Newsletter, many investors have been chasing yield in private credit without fully appreciating downside risk. To the Canso team, understanding covenants, collateral quality and off-balance-sheet exposures is critical in this environment. Click here for the full Corporate Bond Newsletter.
Historically strong conditions continue in credit markets
The team at Canso is keeping an eye on the abundant optimism as central bankers cut rates, equity markets touch new highs, and the Toronto Blue Jays head to the World Series. As they point out in the latest Canso Corporate Bond Newsletter, “We continue to experience historically strong market conditions.”
The S&P 500 rose 8.1per cent and the tech-heavy Nasdaq was up 11.4 per cent in the quarter. The Canadian S&P/TSX composite index outperformed both, up 12.3 per cent in Q3 and 23.3 per cent on the year, as it is benefited from a resource-heavy sector representation. Falling government yields lifted bond indices higher, while the additional boost from shrinking risk premiums drove corporate bond market outperformance. U.S. investment grade and high-yield markets were up seven per cent through the first nine months of the year, while Canadian bond markets are a bit behind because of a steepening yield curve.
The belle of the ball though, seemed to be gold, which gained 12 per cent in Q3 for a gain of 60 per cent on the year, rising above US$4,000 an ounce for the first time ever. Some of the shine rubbed off on silver, which surpassed US$50 an ounce, eclipsing its 1980s high.
“We don’t endeavour to predict the future and will happily leave the dubious task of forecasting to someone else,” the Canso team wrote. “Our focus is, as always, on finding undervalued securities. And as we have been saying for some time, it is getting harder and harder to find value.”
BBB issues continue to outperform
The team pointed out that credit spreads in the higher-quality investment grade side of the corporate bond market continued to perform well, as spreads in both Canada and the U.S. were 12 and 13 basis points tighter in the quarter. “With the continued rally, the wake of the Liberation Day widening has dissipated, and spreads are now comfortably tighter this year,” they noted. “Canadian spreads now sit inside 100 bps for the first time since 2021 while U.S. investment grade continues to look increasingly expensive, finishing the third quarter at 76 bps.”
However, the stand-out performer continues to be the BBB component of the Canadian investment grade index. “We have been calling attention to this trend for a few quarters now and do so again,” the Canso team wrote. “Our attention has largely been in the long end of the curve where bonds have repriced tighter and tighter. The last time spreads were this tight, the first place you’d look to fix that leaky sink was the Yellow Pages. Yellow Pages, coincidently, was one of the largest BBB rated issuers at the time.”
The Canso team looked for insights by going back to June 2007, the last time the BBB index traded inside of where it sits today. Since then, the overall size of the index has grown almost eight times, from $35 billion then to $270 billion today. The BBB component now makes up 45 per cent of the Investment Grade Index versus only 16 per cent then, and only three names stayed in the Top 10: Bell Canada, Telus and Westcoast Energy. Bell Canada and Telus have each grown their Canadian dollar borrowings significantly, while Westcoast Energy now sits under the Enbridge umbrella. Three other names—Daimler Canada Finance, Yellow Pages and Encana—have left the index through restructurings, downgrades and relocations south of the border. And the final four companies remain BBB issuers but have been supplanted by new entrants. What was a diversified list across multiple sectors is now dominated by pipeline and telecom companies.
No issues with new issues
In the past, the team at Canso has written about the seeming closure of the new issue preferred share market in Canada, which hadn’t seen a traditional-structure preferred issue since 2022. Last quarter, it finally reopened, with Power Corp. and its related company, Great West Lifeco, coming to the market with $200 million in fixed-rate straight perpetual preferred share offerings.
The team noted that the “deals have both performed well since issuance amidst a product starved and flow driven market” and “[we] are encouraged to see the reopening of the market, but we are not convinced this is a sign of a changing tide.”
Caveat emptor
The Canso newsletter pointed to some less happy news, like the bankruptcy of First Brands Group, a Michigan-based auto parts company. The collapse rippled through the private credit market, with hundreds of collateralized loan obligations (CLOs) exposed and some of the biggest names on Wall Street facing losses.
“The First Brands Group bankruptcy is an example of debt deals gone wrong in a hot credit market,” the Canso team wrote. “It serves also as a reminder of the risks that come with the opaqueness of the private credit market. As we have said before, many investors have been chasing yield in private credit without fully appreciating downside risk. Credit investors, public and private alike, risk being blindsided in the absence of deep fundamental due diligence. Digging into covenants, understanding collateral quality, and scrutinizing off-balance-sheet exposures is more critical than ever in the current market environment.”
The team at Canso believes that this is a time for vigilance, and they continue to favour quality and liquidity, adding that investors should remain mindful of the risks that accompany complacency, even as pockets of opportunity persist.
Disclaimer: This story was created by Canadian Family Offices’ commercial content division on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication