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Hot Canadian bond market could leave some burned

Friday, October 26, 2012

SEAN SILCOFF

OTTAWA -- Canadians have an apparently unquenchable thirst for yield. In the 24 months through September, investors poured a net $27-billion into bond funds in Canada, at the same time as they redeemed $24-billion in equity funds, according to the Investment Funds Institute of Canada.

Those who are pouring their money into bonds should pay heed to what's happening behind the scenes. As bond fund managers chase yields at a time of rock-bottom interest rates, there are early signs that the traditionally conservative Canadian debt market is getting frothy. That could be setting investors up for disappointment later on.

In part, this is a global phenomenon. Central banks around the world have pushed rates so low that buyers of government bonds are taking increasingly risky bets on investment-grade corporate debt, junk bonds and preferred shares in an attempt to beat their benchmark indexes. More demand for debt issues is driving up bond prices.

A typical Canadian bond deal a few years back might have had 60 buyers; now that number may be 80, and pretty much every deal is selling out or being upsized, veteran fund managers say. While spreads over government debt aren't as narrow as they were in the overheated 2006-07 period, they have dropped to levels last seen during the post-recession bounce of 2010.

Issuers are capitalizing on the appetite for bonds by dictating terms that are more advantageous to them, while many buyers appear unperturbed about accepting looser covenants than in the past.

One recent issue saw AltaLink Investments LP - an entity indirectly controlled by SNC-Lavalin Group Inc. - issue $200-million in medium-term notes. The problem? The underlying operating assets of AltaLink are held in a subsidiary of the issuer and can't be pledged against the bonds due to regulatory restrictions, so bond buyers are going on faith the business will keep humming along.

Meanwhile, convenience store giant Alimentation Couche-Tard is trying to sell $1-billion in bonds that are offering the same returns as grocery store titan Sobey's Inc. - despite the fact Couche-Tard has just made a huge acquisition overseas and has a credit rating one notch lower than Sobeys, a stable, slow-growing Canadian grocer.

Another sign of buyer enthusiasm is the return of the "maple bond" - Canadian-dollar debt issued in Canada by foreign entities. This year, issuers have sold close to $5-billion in maple bonds, up from $2.75-billion in all of 2012, and several issues have been supersized from their original offering due to heavy demand.

This is perfectly respectable paper, but maple bonds are less liquid in the resale market because many of the issuers aren't as well known in the Canada as domestic issuers, and thus prone to steeper drops in value when credit markets seize up. Investors who are reaching for yield today could face poorer returns tomorrow when market conditions change.

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