On the surface, the second quarter was peaceful for corporate bond markets. Even as Canada’s central bank became the first in the G7 group of nations to cut interest rates, returns were muted and credit spreads moved only slightly. Yet, as the team at leading Canadian institutional investment management firm Canso Investment Counsel wrote in their latest Corporate Bond Newsletter, investors would do well to pay attention to what occurred in the second quarter—including a record-setting Canadian corporate bond issue and emerging risks to lenders in the U.S. high yield market.
Click here for the full Corporate Bond Newsletter.
The tide turns—for now
On June 5, The Bank of Canada signalled that the rate hiking cycle it started more than two years ago had come to an end, when it lowered its benchmark rate by 25 basis points. It then followed up in late July with another 25 bps cut, bringing the overnight rate to 4.5 per cent. As the Canso team noted, inflation in Canada has been trending below three per cent—within the BoC’s one-to-three-per-cent target band—throughout 2024, so the Bank might seem justified in reversing course now. But a key question remains, according to the newsletter: “Have central bankers been successful in their ‘Command and Control’ approach or will wage gains and accommodative fiscal policy cause inflation to be sticky?”
If you have been keeping up on Canso’s thinking about inflation and money supply, which remains historically elevated after its dramatic expansion during the pandemic years, you will know that the team has its reservations about declaring victory too soon.
Nothing to see here?
There was at least one notable event in Canadian fixed income in the second quarter: a secured bond issuance from Coastal GasLink, a pipeline that will feed the liquefied natural gas project LNG Canada in Kitimat, B.C., due to come online in 2025. The issue originally had a cap of $4 billion, but demand was so strong that it expanded to $7.15 billion across 11 tranches of debt, making it “a record deal in Canadian corporate history,” the team wrote. Enthusiasm for the GasLink bonds continued in the secondary market as spreads tightened.
Still, the Canso team wrote that even as the interest rate regime shifted, credit markets were “relatively subdued” in Q2. Short bonds rallied before the Bank of Canada’s early-June cut, pricing in much of the eventual impact. “Bond market performance was largely the result of running yield,” according to Canso. Returns in investment grade and broad bond indices were only marginally positive.
Investment grade credit spreads in Canada did not end up doing much of anything over the quarter. On the back of government bond yields spiking in the second week of April amid high inflation data, spreads followed suit and then tightened significantly in May, but widened again in June, finishing the quarter about where they started. Canadian spreads have tightened over the first half of the year, with a recovery among financial issuers being a key factor.
In the United States, too, spreads compressed in the first half, reaching a cycle tight in May, even as markets were still waiting for the Federal Reserve to change track on rates. “It is impossible to say if this is the bottom [for spreads],” Canso wrote, “but either way, the U.S. market continues to be expensive in absolute and relative terms.”
High yield anxiety
The risk in the U.S. corporate market is especially acute in high yield, with spreads that ended the quarter 20 bps tighter than the start of the year. The Canso team remarked that much of that tightening has occurred among single B-rated bonds, where spreads narrowed by more than 40 bps—creating the “tightest levels for the category since the eve of the Great Financial Crisis back in early 2007.”
The team noted that high yield new issuance was strong in the second quarter—and, citing Pitchbook LCD data, that 85 percent of it was the result of refinancing activity. That means there was not actually much new bond supply, “and managers with an index benchmark have had little choice but to participate,” the newsletter noted. “With each successive deal, we see more and more bonds being priced for perfection.”
The result? “More and more lower quality B rated companies [could] get in on the act.”
It’s a dog-eat-dog world
The Canso team sees trouble brewing in the riskier depths of the credit markets. They noted the increase in Distressed Exchanges and Liability Management Transactions (LMTs), which “typically involved moving assets and collateral to different subsidiaries or introducing new ranking levels within a company’s capital structure.” Canso described such maneuvers as often “a lever of last resort for companies unable to raise new money or unwilling to accept punitive terms,” and their surge in popularity helps explain why corporate defaults have risen only modestly in 2024.
From a lender’s perspective, the trouble with this debt-shuffling game is that “there can be a large dispersion in recovery rates, which is underappreciated in aggregate metrics,” the team wrote. In many LMTs, “aggressive investors may come into the lender group … and restructure new debt in a way that comes at the expense of any non-participating borrowers.”
It is, the newsletter noted, a situation ripe for what it called “creditor on creditor violence, where an improvement for one lender comes at the expense of another.”
The onset of new challenges can bring new opportunities. The Canso team sees “more and more credit opportunities emerging” in this environment. They noted that while default rates were low in the second quarter, the proliferation of distressed transactions suggests increasing stress among highly indebted companies—and there were even some Q2 issues with yields higher than 12 per cent. Now, the “opportunity lies in rolling up your sleeves, doing the credit work, and identifying the deals that are well structured for lenders versus the ones that are not,” they wrote. It’s “a challenge our investment team is eager to take on.”