Welcome to the inaugural issue of the Canso Bond Value Letter, a monthly publication of Canso Investment Counsel Ltd. In this letter we hope to comment on trends and values in the Canadian corporate bond market from our unique position as a dedicated and value-based corporate bond manager. We thought it appropriate, given the cold winds blowing through the world's capital markets, to start our commentary with a song that should be sung stoically to the tune of Gordon Lightfoot's Edmund Fitzgerald:
"The legend lives on from the Bond Traders on down of the time when the market is gloomy.
Issues it is said, always give up some spread when the winds of November come early."
Indeed, where the last quarter of the year is traditionally a period where corporate spreads widen (corporate bond yields rise relative to Canada bond yields), October and November of 1997 will be long remembered for their savagery. Not since the fall of 1992 when the real estate collapse and the aftermath of the recession saw large scale portfolio liquidation, has there been anything close to the spread increases or "gapping" that we are now seeing.
Normally, spreads will widen in the fourth quarter because of excess supply. Traders squaring their books for their firm's October 31 fiscal year end tend not to be buyers and actually liquidate bonds that they don't want when their books are closed. Financial institutions, especially insurance companies, have mostly completed their buying programs. Performance-based investment managers have made or broken their performance record already and are unlikely to step up to the plate. On the issuance side, treasurers see the opportunity to get new funding on the balance sheet before their December 31 yearend. They rush to get bonds issued before the Christmas doldrums set in and buyers disappear on vacation. This preponderance of sellers over buyers usually makes for a value-buying opportunity in corporate bonds. This year, however, the collapse of the equity markets and a large overhang of corporate bond supply means that fear is in the air.
What a difference a couple of months can make. As you might know, we had the summer off as we were awaiting regulatory approval to start Canso. From a summer refuge in Muskoka, one had to wonder about the sanity of the Canadian corporate bond market. Spreads had collapsed to very low levels. BBB rated industrial issues with anorexic yields were touted as "good diversification". High yield issues were coming at low spreads with zero coupons! The summer vogue in issuance was real estate holding company bonds. Hadn't anyone learned the lessons of Bramalea and O&Y?
The psychology and cycle of the corporate bond market are not that much different than those of the equity markets. Initially powered by underlying cashflows, corporate bonds are bought by value investors in the illiquid recessionary period. These investors, having done their credit homework, buy decent credits at cheap prices (high spreads versus Canadas). What about credit ratings, you may say? When the markets are running scared, there are few willing to step up to the plate. This was the situation in the fall of 1992. I remember this period well, as it was a value bond buyer's fantasy. Just for fun, I have listed below the spreads on a few of the corporates that I was buying then and the current spreads for comparison:
Issuer |
1992 Spread/Rating |
1997 Spread/Rating |
| Sears Canada | 425 bps/BBB(high) | 60 bps/BBB (high) |
| Hammerson Canada | 330 bps/A(low) | 60 bps/A (low) |
| Scotts/Laidlaw | 270 bps/A(low) | 80 bps/BBB (high) |
| Provigo | 250 bps/A(low) | 70 bps/BBB (high) |
| General Motors Acceptance | 270 bps/A | 45 bps/A |
| Chrysler Credit | 540 bps/BBB | 50 bps/A |
In most cases, the credit ratings are lower or the same but the spreads have collapsed. Take General Motors Credit bonds for example. Their rating is the same now as in 1992 but the spreads have collapsed from 275 bps to 45 bps. The big difference is illiquidity. When the herd is starting to liquidate at any cost, out of an irrational fear of GM's collapse, the value buyer is the buyer of last resort who puts a high price on supplying his or her capital.
These shrewd bond purchases of 1992 looked pretty good by 1996. The recession was over, the businesses and cashflows underlying these bonds were recovering. Take Sears Canada, for example. It was obvious into 1993 that Sears had survived the recession. Sears credit spreads narrowed from their wide point of 425 bps to 125 bps. The buyer of Sears 11% of 1999 had seen a tremendous risk-adjusted return. The additional yield of 13% (425 bps for 3 years) combined with a capital appreciation of 9% (spread narrowing of 300 bps on duration 3) for a total return out performance of Canadas of 22%. All from a investment grade bond rated no lower than BBB throughout this period!
Then the "momentum players" appeared. Not doing anything as complicated as long-term valuations, they simply buy, as in the equity market, because things going up (spreads narrowing for bonds) should be bought. They chased the Sears spreads and all corporate spreads in to very "tight" levels in their lust for out performance. Momentum players don't rely on a valuation discipline. The only difference to them between 100 bps and 50 bps spreads is that one is lower. Spread doesn't represent payment for credit or default risk. It's just a number.
The peak of this momentum buying occurred this past summer which, I would hazard a guess, was the peak of the corporate bond frenzy for this cycle. Even the investment dealers were getting cocky. Corporates were the only game in town with any spread left and everyone knew that corporate spreads could only narrow. The corporate bond debacle of the early 1990s was a distant memory. It's an interesting comment on this period that, in going over deals from the summer, I've found much of the marketing material dealt with the "coming shortage of government bonds" and not the specifics of the particular issue or issuer. "If you're nice to us", seemed to be theme, "we'll let you by some of our bonds". Most of the summer crop of new issues blew out the door, well over-subscribed.
It's a different picture now. Corporate issues now sit on the dealer's book like last year's fashions at a close-out sale. On the back of the summer's issues came an onslaught of real estate issuance. As Real Estate Investment Trusts (REITS) started to issue bonds fast and furiously, it became very apparent that there were a lot of corporate bonds waiting to be issued. Spreads started to widen in anticipation of supply. Then the equity markets collapsed, potentially closing this important source of corporate funding to treasurers. It wasn't long before the momentum players started to jump ship. Remember, they buy things going up and sell things going down. It's a brave bond trader who'll stand in front of the clogged exit of the burning market, assisting the panicking crowd fleeing the momentum arena.
What seemed to be forgotten in the summer madness is that there isn't really going to be a shortage of corporate bonds. Just like the well-known and positive effect of declining interest rates on personal mortgage debt, the drop in interest rates has created a lot more bond value. The $10 million operating cashflows of an issuer that used to finance $100 million in debt at 10%, now can finance $200 million in debt at 5%. Corporate issuers can finance twice the debt with the same cashflows. But, you might say, these issuers are new and improved and won't lever themselves up. WELL, READ THE PAPERS!
In a newspaper article just before real estate spreads started to blow out viciously, a major summertime issuer of real estate bonds was quoted on the problems of the real estate market. To paraphrase: "The capital is easy to get, it's finding the buildings to buy that's the problem". Another of the major summertime issuers was described as having an "aggressive acquisition program". Based on our simple debt service calculations above, it's a fair guess that the peak in real estate prices will be about double the bottom since issuers can now pay twice the price for the buildings!
What about the coming shortage of government bonds, you might ask? Well, those straight-line forecasters of trends continuing ad infinitum are the same experts who predicted Canada's impending bankruptcy and rescue by the International Monetary Fund a mere three years ago. Been to any "Canada Hitting the Wall" conferences lately? Most forget that Canada's cashflows have about the same cyclical commodity profile as a natural resource issuer. Canadian monetary policy is tightening again which will increase nominal interest rates. Stir in the privatization initiatives of the last few years.
Privatizations are a story of market romance. Government sells "Crown Jewel" asset. Government gets money. Newly liberated "Crown Jewel" corporation meets capital market. Capital market likes cashflows of "crown jewel", especially monopoly powers conferred by willing government to get debt off balance sheet. Crown jewel issues lots of debt. Everyone lives happily ever after. $950 million in Toronto Airport Authority bonds anyone?
The moral of our story: Don't buy corporate bonds on momentum or "big picture" macro factors. Stick to the boring cashflows. There will be some buying ahead for the educated corporate bond consumer. Keep that powder dry!
On the notes of cashflow and structure, our next edition will sort out the real estate sector and take a good look at the debt issuance of REITs. I'm toying with the title: "Are Too Many REITs a Real Estate Wrong?"
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