Corporate Bond Market: Ignore It At Your Peril
By: Doug MacDonald
Speaking with private and institutional investors across Canada, we continue to be amazed at the lack of attention given to the corporate bond market. Are corporate bonds still being punished for the shakeout of the last recession of 1990-91, when such highlyrated companies as Olympia & York became insolvent? We hear comments like: “too risky,” “why not just own governments,” “the market’s too small,” and “lack of diversification.” Valid questions for 1991, perhaps, but, in 2003, absolutely not.
Corporates are one of the most compelling asset classes in which we can invest and there are several factors responsible for this:
- Corporate bonds outperform governments over the long-term
- Corporate market continues to grow and develop
- Corporate market has high-quality companies
- Corporate market provides excellent risk-adjusted returns
Furthermore, in the present low interest rate environment, a meaningful allocation to corporate bonds will add significantly to a portfolio’s return.
Corporate Bonds Outperform Governments Over The Long-term
If we examine the relative historical performance of the corporate bond market versus the Government of Canada (GOC) market on a total return basis, we generate some interesting findings. To start, in the last 15 years (ending 2002), the corporate bond market outperformed the GOC market in 12 of the 15 annual periods (see Chart A). Even in the prolonged spread widening period of 1989 to 1992 (the last recessionary period), the corporate market only underperformed the GOC market in one of those four years, on a total return basis.
The reason for this phenomenon is relatively simple – the power of the coupon. Total return for a fixed income instrument is the sum of capital gain and interest income. Corporate bonds are purchased at spreads over GOC bonds. This leads to increased income for the corporate over its GOC counterpart. Therefore, even in a period of significant corporate spread widening (which would lead to a capital loss on the corporate versus the GOC), the corporate often outperforms the GOC due to the excess income earned. As at September 30, 2003, the excess annualized return on corporate versus GOC bonds over threeyear, 10-year, and 15-year periods was 102, 89, and 83 basis points respectively (see Chart B).
Market Continues To Grow And Develop
The corporate bond market represents an ever-increasing proportion of the Canadian fixed income market. Corporates have increased from 10 per cent of the market in 1993, to 20 per cent in 1999, to 27 per cent today (see Chart C). We expect this figure to rise to 30 per cent in the next few years.
The reason for this is two-fold:
- government issuance continues to shrink as a result of budgetary surpluses
- corporate issuance continues to increase, especially in the areas of securitization and infrastructure deals like Highway #407, a toll highway north of Toronto In the late 1980s and early 1990s, the combined $62 billion federal/provincial annual budget deficit led to massive government debt issuance which ‘crowded out’ corporate bond issuance. This reversed itself m i d w a y through the 1990s as governments balanced their books and a ‘crowding-in’ o c c u r r e d . Also, off-balance sheet financing became more prevalent in this period: financial institutions were shrinking their balance sheets to increase ROA and governments were just plain shrinking. This led to a huge issuance in the areas of asset-backed and infrastructure financing. Corporate issuance overall has expanded from a paltry $7 billion in 1994 to $38 billion in 2002. Canadian corporations look to the Canadian market for largescale financings (see Chart D).
There are more than 100 investment grade (BBB and above) companies in which to invest today and while the Canadian market will never be as large, liquid, or diversified as the U.S., it is absolutely possible to have a fully diversified, Canadian investment-grade corporate bond portfolio in 2003.
Corporate Market Has High-quality Companies
‘Corporate bonds are too risky’ is one of the most common statements made by investors in relation to this market.
However, are they aware of the risk embedded in their equity portfolios? Reviewing the credit ratings of S&P/TSX companies, we estimate that almost twothirds of the component companies are below-investment-grade! No company has a triple-A rating! The reason for the lack of credit quality is because the S&P/TSX contains a large number of cyclical companies as well as a large number of highgrowth companies without positive cash flow, which leads to non-investment-grade ratings. This does not infer that they are poor companies, only that, from a credit perspective, their quality is not high enough to warrant an investment-grade rating. The S&P/TSX is truly a non-investment grade index and, remember, debt ranks before equity in all capital structures.
In contrast, the Canadian investmentgrade corporate market (represented by the Scotia Capital Corporate Bond Index) is a truly high-quality market. These companies are all rated triple-B and above, with a large percentage being rated A.
The triple-A section is composed of assetbacked securities, whose high ratings are due to certain credit enhancement provisions. The market contains some truly high-quality, large capitalization, liquid companies who are the ‘best in class’ in their industry.
Corporate Market Provides Excellent Risk-adjusted Returns
Fixed income portfolios have three basic components of risk:
- interest rate risk
- liquidity risk
- credit risk
Interest rate risk is the sensitivity of a portfolio’s value to changes in interest rates. Liquidity risk is the ability to sell the securities in a portfolio in a timely and cost-effective manner. Credit risk is the risk that the securities in a portfolio may deteriorate in credit quality.
All portfolios require a decision on the risk tolerance to achieve a certain return or value-added objective. Investors should be wary of fixed income portfolios that attempt to add value strictly through the use of interest rate anticipation. While these portfolios will tend to have lower credit risk, they will likely have very high interest rate risk that overwhelm any improvement in the portfolio’s credit risk profile. Historical studies indicate that adding corporate bonds to a portfolio will increase the risk adjusted return of a portfolio. Although credit risk will be increased somewhat, this is more than offset by the return from higher yielding corporate bonds, leading to increased risk adjusted returns.
Corporate bonds outperform Canada bonds substantially with basically the same volatility leading to a higher risk-adjusted return. In addition, one should compare the favourable metrics on corporates with that of equities, which underperformed both the corporate and Canada bond markets with triple the risk!
Past And Present
In 1988, 10-year Government of Canada bond yields were 10 per cent and Corporates represented a meagre 12 per cent of the Canadian fixed income market. Pension plan sponsors could largely achieve their return objectives through government bonds combined with some equity exposure. Fixed income managers could achieve first-quartile returns without corporate bond exposure, assuming they correctly anticipated the direction and magnitude of interest rate changes.
Fast forward to 2003, 10-year Government of Canada bond yields are a measly five per cent. Equity market returns are becoming less certain but more volatile and corporates now represent 27 per cent of the Canadian fixed income market. The choice seems very clear – Corporate Bonds.
Inclusion of a corporate bond component to an investor’s fixed income portfolio will add significantly to a portfolio’s return, without a tremendous increase in risk. What is necessary to achieve this successfully? It requires:
- the utilization of a corporate bond strategy as part of one’s overall fixed income philosophy.
- access to significant experience and expertise to execute such a strategy.
- access to a global equity team to assist in this strategy.
The corporate bond market is here to stay. Is your portfolio positioned to take advantage of it?
Doug MacDonald is vicepresident, fixed income investments, at KBSH Capital Management Inc.
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