Leverage risks rising in corporate bonds, RBC manager says

"The cushion gets smaller" for issuers against unforeseen events.

Michael Ryval 8 June, 2017 | 5:00PM

Canadian corporate debt denominated in foreign currencies has been growing at a prodigious rate, such that investors should be aware of the potential challenges with highly leveraged issuers, says Marty Balch, senior portfolio manager at Toronto-based RBC Global Asset Management Inc.

"Since 2012, Canadian companies have increased the amount of debt in foreign currencies at a rapid rate. Foreign-denominated debt now accounts for about 57% of total corporate debt, versus 44% in 2012," says Balch, a member of the team that oversees the $7.9-billion RBC Global Corporate Bond. He noted that there is about $720 billion in foreign-denominated debt, compared to $298 billion five years ago. Total corporate debt stands at $1.26 trillion.

Much of the 140% increase in foreign-denominated debt is due to Canadian banks issuing bank paper in foreign markets where they have operations. "Another factor is that there have been new products as global markets are more developed," says Balch, a 26-year industry veteran who graduated in 1991 with a BA in economics from the University of Toronto and joined RBC GAM in 2000. The most common new product, says Balch, is covered bonds, or bonds backed by a pool of mortgages on the bank's balance sheet. They are mostly issued outside Canada, even though they are Canadian residential mortgages.

Growing leverage on corporate balance sheets is the chief risk, according to Balch. "Companies are carrying a higher debt burden than they have in the recent past. One of the measures we look at is the debt to earnings before interest depreciation and amortization (EBITDA) ratio," says Balch. "It's gone up from 1.5 times in 2012, to 2.8 times now, but it's been as high as over three times."

Part of the significant increase in the ratio is attributable to the ailing energy sector. But it has also crept up in the telecom sector, and elsewhere. "For me," says Balch, "it's all about the trend and what the trend means as far as flexibility is concerned going forward, in the event there is a slowdown in the economy or there is an external shock."

Ironically, despite the rising leverage, the cost of servicing the debt has remained relatively stable, thanks to razor-thin interest rates. "You can have twice as much debt as five years ago, but the coupon is half of what it used to be, so your interest service is still the same," says Balch. "But if interest rates go up, the spreads go out, and the debt service can go higher. There is less flexibility and less of a cushion in the event of a slowdown."

Balch says there's a lot of uncertainty in the market around growth, and concerning geo-political risks such as North Korea. "What's happening with China? Is tightening holding back its potential growth?" says Balch, adding that similar issues such as the Brexit talks with the European Union are all bound to affect Canada.

"We are in this slow-growth, low-inflation, muddle-through economy, which from a corporate view is not bad," says Balch. "It's just that these companies have levered up. And that's whether they are returning money to shareholders through share buybacks, in a massive way, or it's been used to make acquisitions. We are not in as good a spot as we were five years ago."

In Balch's view, Canadian companies "got religion" when the credit markets almost dried up during the global financial crisis and they became fastidious about cleaning up their balance sheets. Conditions were "bondholder-friendly" for a while, as far as corporate behaviour was concerned.

Rising corporate debt that is accompanied by higher cash flow is not a problem, says Balch. "When debt rises faster than cash flows, however, it starts to restrict a company's ability to handle unforeseen challenges in the future. The cushion gets smaller."

Lower credit quality can lead to wider spreads between corporate and government yields, Balch adds. "If spreads widen and corporate bonds underperform government bonds, for me, it's a warning sign. It's something which we are monitoring very closely to see if it continues. We may not see a continuation in deteriorating credit quality, in this low-growth, low-inflation environment. But, again, it just leaves a company with a smaller cushion to absorb any shocks."

The managers of RBC Global Corporate Bond have taken a more conservative stance relative to the fund's combined benchmarks (dominated by the 40% in the Barclay U.S. Corporate Bond Index). As spreads in the high-yield space have narrowed versus government bonds, Balch and co-manager Frank Gambino, vice-president, and Soo Boo Cheah, London, UK-based senior portfolio manager, have lowered the exposure to high-yield bonds to 7.7%%, below the 10% weight for the Bank of America Merrill Lynch U.S. High Yield Index.

The fund's 10% weighting in emerging-market bonds is slightly below the benchmark weight of 11%. About 82% of the portfolio is in investment-grade corporate bonds, of which about 42% is in the U.S. The fund's duration -- a measure of its sensitivity to changes in interest rates -- is 6.2 years.

Today, high-yield spreads have narrowed to 390 basis points (bps) over benchmark U.S. treasury bonds. "Could spreads go tighter? Yes, maybe, if demand-supply conditions prevail in the oil patch. But that's not our base case," says Balch. He thinks the market has "50 bps of tightening left, so your potential gains are a lot less than they were (a year ago.) High yield is a risky asset class and we're being prudent."

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Michael Ryval

Michael Ryval