The corporate bond market looks vulnerable, now that the Bank of Canada (BoC) and the U.S. Federal Reserve Board are set on a course of increasing overnight interest rates. The reason? Investors’ preference for government debt, which has no default risk and rising payouts, could lead to a corporate bond sell-off.
Specifically, as central banks increase overnight interest rates and governments increase their borrowing to cover deficits, the yield spreads between corporate and government bonds expand. Says Edward Jong, vice president, business development, at Toronto-based T.I.P. Wealth Manager Inc.: “Corporate spreads over government debt have widened. What we’re seeing is ‘crowding out’.”
Increasing government borrowing needs, combined with higher interest payouts, will result in investors turning to government bonds. That means less will be left on the table for corporate borrowers, Jong says. In turn, this will force corporate issuers to ante up coupon interest rates, take less from investors at lower coupon interest rates or look elsewhere for money. The companies can either borrow abroad or issue stock for which repayment is not required and dividends are discretionary.
As a consequence of this crowding out phenomenon, Jong anticipates debt/equity ratios will rise. That move will be reflected by the end of central banks’ efforts to push down interest rates to near zero nominal yield. In fact, he adds, sub-zero real yields are over in the U.S. and Canada.
So far, corporate balance sheets are taking the stress of higher interest rates well. Says Eric Beauchemin, group managing director of corporates at Toronto-based credit-rating agency DBRS Ltd.: “We’ve seen an increase of leverage as a result of share buybacks, but there has not been a decline in the quality of balance sheets that we track.”
Investment-grade bond quality is stable now, but Jong anticipates another 75 basis points will be added to interest rates at the short end of the yield curve in 2019. If Canada’s economy continues to improve, then healthier top-line corporate sales will more than make up for heftier borrowing costs. Still, there will be an effect, Jong says: “We foresee corporate interest rate spreads expanding as rising interest rates for government debt crowd out corporate borrowers.”
Not only will there be crowding out, but companies’ stocks that pay dividends, which compete in the income market with bonds, are raising payouts. Standard & Poor’s Financial Services LLC anticipates U.S. companies that pay dividends will have raised their payouts by 9% for all of 2018. Corporate bond interest rates will have to rise just to keep up.
Canadian corporate bond yield spreads vs government debt are wide already – and growing wider. For example, a Fairfax Financial Holdings Ltd. 4.25% issue due Dec. 6, 2027, rated BBB (high) by DBRS, has recently been priced at $97.05 to yield 4.65% to maturity, compared with the Government of Canada 1% bond due June 1, 2027, recently priced at $88.38 to yield 2.52% to maturity. The Fairfax issue carries almost twice the federal yield – a huge premium for an eight-year investment-grade bond. It also holds more risk than government bonds, which are backed by the power to tax and print money.
Much depends on what happens with U.S. debt issuance. Tax cuts already in place suggest that the US$15-trillion federal debt will rise as continuing U.S. deficits force that government’s bond yields upward. Further tax cuts and the cost of servicing the vast U.S. federal debt will push net interest costs to US$915 billion in 2028 from US$523 billion for the year ended Sept. 30, according to data from Bloomberg LP.
Thus, what happens to corporate bond returns depends not on the quality of credit ratings – which should hold steady, according to DBRS – but on price moves driven by the immense U.S. federal debt pushing up all interest rates. U.S. federal borrowing needs are going to soak up loanable funds. Canadian rates inevitably follow. Existing bond prices inevitably will drop, adding to value erosion.
So far, U.S. treasury bond sales have been relatively heavy at the long end of the market, says Chris Kresic, head of fixed-income and asset allocation at Jarislowsky Fraser Ltd. in Toronto: “The Treasury had overweighted its sales of long bonds so that the average term of the stack of debt is the longest ever. [The Treasury is] shortening terms to maturity so it will issue more bills than long bonds.”
The crowding out trend is likely to be the theme of the bond market in 2019 as investors move to higher-quality government bonds. Investors can capture higher government-driven interest rates in U.S. treasuries and the rising interest rates that the BoC has promised. The implication is that lower- quality corporate debt will have to go looking for buyers, Jong says: “Yields are backing up in higher-quality corporate debt, so investors will be reluctant to pick up lower-quality corporate debt.”
The natural evolution of this view is that holders of lower- quality debt will tend to sell in favour of higher-quality corporate and government debt. Patience will pay off for bond investors who seek higher yields and higher quality, Jong believes. But corporates are more vulnerable to price corrections as government bond rates rise.