Canada’s Aversion to Debt

By Roger Conrad • March 26, 2013 • Canadian Edge Weekly

This week, Canada’s biggest phone company BCE Inc (TSX: BCE, NYSE: BCE) issued CAD1 billion in 10-year notes. Management’s purpose, however, was not to use today’s record-low corporate borrowing rates to lever up, but rather to continued slashing interest expense.

The BCE notes pay a coupon rate of 3.35 percent. That’s a premium of 145 basis points–or 1.45 percentage points–above recent rates paid by the Canadian government. By contrast, BCE paid a premium of 181.7 basis points when it issued 10-year debt in May 2011.

Savings from refinancing stand to be substantial. The company has bonds maturing June 30, 2014, with a coupon yield of 4.85 percent, as well as some longer maturities paying out more than 10 percent. And given the success of this bond issue, we’ll likely see more.

Thus far in 2013, Canada’s stock market, as represented by the S&P Toronto Stock Exchange Composite Index (SPTSX), is up less than 2 percent. And it’s actually underwater in US dollar terms. The 12-month return of the SPTSX is little better–just 1.6 percent in US dollar terms.

Those paltry returns–which lag way behind the US stock market–are partly due to a drop in the Canadian dollar below parity. But Canadian stocks in general have also been dragged down by weakness in several key sectors, including energy, where drilling has taken a hit due to low natural gas prices and record oil price differentials.

But in the fixed-income arena, it’s still very much a sellers’ market for Canadian corporate bonds. Canadian inflation is running at its lowest level since 2009, and below the Bank of Canada’s 1 percent to 3 percent annualized target as well.

Meanwhile, global investors appear to be refocusing on Canada’s strong finances, which are a welcome contrast to the ongoing turmoil in Europe and uncertainty in Asia.

According to data compiled by Bloomberg, BCE and other Canadian telecoms issued CAD2.7 billion in bonds in 2012. That was down by half from CAD5.4 billion in 2011. Telecoms account for a 7 percent share of Canada’s corporate bond market, according to the Bank of America Merrill Lynch Canada Corporate Index. And the debt-aversion trend has been reflected across other industries as well.

There have been some three-dozen major bond issues in Canada year to date, including BCE and The Bank of Nova Scotia (TSX: BNS, NYSE: BNS) totaling roughly CAD24.8 billion (USD24.3 billion). The current pace of bond issuance is still well below that of 2011. But it is 18 percent ahead of last year, and much better than the 11 percent drop in activity in the US.

High Yields Get into the Act

Issuing debt to strengthen balance sheets doesn’t do much for growth. But it should make Canadian firms more resilient during periods of future economic turmoil. Even non-investment-grade companies have jumped into the act. Bloomberg data show Canadian “junk” issues are up 32 percent from a year ago, though this is a much smaller market.

Total Canadian junk bonds outstanding, for example, are estimated at CAD11.4 billion. That compares to the much larger market for investment-grade securities and the $1.2 trillion high-yield bond market in the US. But it’s on track to grow by CAD5 billion this year.

That may sound a lot like levering up, especially since it involves companies with often less-than-stellar finances. But here too, companies are issuing new bonds to strengthen balance sheets.

That’s because most sub-investment-grade companies rely heavily on credit agreements to finance activities and expansion. Issuing bonds or “terming out” some of this debt isn’t as favorable for creditors as selling stock. But it does reduce dependence on one group of lenders, and very often leads to increased access to credit under existing deals.

The other way that some Canadian companies have been cutting their debt burden and strengthening balance sheets the past couple years is by deploying cash saved from cutting dividends. The need to deal with debt was at least partly responsible for decisions to cut payouts over the past year at the following companies:

  • Atlantic Power Corp (TSX: ATP, NYSE: AT)
  • AvenEx Energy Corp (TSX: AVF, OTC: AVNDF)
  • Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)
  • Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF)
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)
  • CML Healthcare Inc (TSX: CLC, OTC: CMHIF)
  • Colabor Group Inc (TSX: GCL, OTC: COLFF)
  • Data Group Inc (TSX: DGI, OTC: DGPIF)
  • Enerplus Corp (TSX: ERF, NYSE: ERF)
  • GMP Capital Inc (TSX: GMP, OTC: GMPXF)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)
  • Just Energy Group Inc (TSX: JE, NYSE: JE)
  • New Flyer Industries Inc (TSX: NFI, OTC: NFYEF)
  • Pengrowth Energy Corp (TSX: PGF, NYSE: PGH)
  • Talisman Energy Inc (TSX: TLM, NYSE: TLM)
  • Westshore Terminals Investment Corp (TSX: WTE, OTC: WTSHF)
  • Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)

All of these companies continue to face challenges on the revenue front. For Atlantic, Capstone and Just Energy, it’s the weakened North American power market. For AvenEx, Bonavista, Enerplus, Pengrowth, Talisman and Zargon, it’s been weak natural gas prices and widened pricing differentials between Canadian oil and US oil, due to abundant output and a lack of pipelines to carry it.

The softening global pulp market triggered multiple dividend cuts at Canfor. CML is still adjusting to its withdrawal from the US market. Colabor has been challenged by competition and soft market conditions in the food distribution industry that it’s only now offsetting with acquisitions and improved efficiencies. And Data Group’s digital documents business hasn’t grown fast enough to outpace erosion in its paper business.

A year of reduced activity on Bay Street hit financial house GMP. IBI’s revenue fell due to fewer infrastructure projects and a problem with billing. New Flyer’s bus manufacturing business has suffered as municipal governments have been increasingly cash strapped. And WestShore took a hit both figuratively and literally when a ship crashed into a loading berth at its coal transportation terminal.

Each of these companies could have followed a pattern more familiar to US companies of keeping their dividends level by levering up and waiting for better conditions. Instead, each opted to cut dividends to ensure they’d have the cash to keep business plans on track if there were no improvement.

To be sure, their stocks have suffered for their actions, some quite severely as investors have assumed more bad news to come. Only time will tell whether their recovery plans pan out, or if the skeptics are right and the worst is yet to come. And their stocks are likely to prove volatile in the meantime, as they respond to rumor about their financial health in addition to actual numbers and developments.

Most investors should limit exposure to this group. But if history is any guide, several of these stocks will emerge among the Canadian market’s biggest winners from this point.

And from a big-picture perspective, these cuts are more evidence of Canada’s debt aversion, which more famously shows up in near-balanced federal budgets and central bank policies that strongly discourage real estate speculation. And it’s a big reason why I continue to like this country, regardless of today’s headwinds and, yes, even the recent wave of dividend cuts.

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