Canadian companies issuing high yield debt have historically had little choice but to tap the high yield market south of the border. In recent years, however, an increasing number have been opting to issue Canadian-dollar denominated high yield bonds to investors in Canada. 2010 saw 14 Canadian deals worth more than $3.4 billion, up from $1.2 billion in 2009 – a burgeoning market that has even begun to draw U.S. dealers north to lead domestic offerings. Investors’ appetite for Canadian-dollar denominated high yield debt is strong and growing, as evidenced not only by the foregoing statistics but by the frequency of over-subscribed deals and the emergence of an increasing number of high yield mutual funds and exchange traded funds. Having been involved in nearly half of the Canadian deals in 2010, our group at Stikeman Elliott is anticipating another busy year in 2011 as a rising economic tide buoys weaker companies that are motivated to complete corporate borrowing and refinancings while interest rates are low.
What is high yield debt?
Also known as “non-investment grade debt”, “speculative grade debt” or “junk bonds”, high yield bonds are debt securities that are too close to the speculative end of the risk spectrum to qualify as investment grade. In other words, they have an elevated probability of default or loss upon a credit event (e.g. bankruptcy) relative to blue chip or government debt. Issuers that do not qualify for investment grade ratings from major credit rating agencies must pay a higher interest rate and typically build in investor-friendly structural features to attract investors to these relatively high-risk investments.
Advantages for issuers and investors
Prior to the development of the domestic market, Canadian issuers’ reliance on the U.S. market forced them to pay for a swap back to Canadian dollars. By raising money in their home currency, Canadian issuers lower their cost of capital and eliminate foreign exchange risk. The growth of the high yield market has also allowed them to manage refinancing risk and, as the pace of M&A picks up, to finance acquisitions. The Canadian high yield market offers mid-sized companies capital-raising opportunities on terms that compare favourably to bank debt.
From the standpoint of investors looking for something safer from a recovery perspective than an equity investment, the demise of the income trust market, slow economic growth and low interest rates have made the Canadian high yield debt market one of the best available means of investing higher up the corporate capital structure. High yield debt answers the demand for yield by those who have become discouraged by low spreads over Treasuries, and of course investors are as keen as issuers to avoid the foreign exchange risk associated with purchasing U.S. dollar-denominated bonds.
The growing maturity and sophistication of the market itself are also contributing to its growth. For example, to create a larger, viable and liquid market, many dealers are consistently offering smaller $5-10 million investments in most issues and are also supporting a secondary exempt trading market. In addition, a downward trend in high yield bond default rates is expected to stimulate investment in high yield retail mutual funds while maintaining strong institutional demand. These factors have resulted in more buyers leading to tighter pricing for issuers, as offerings are often over subscribed.
Profile of the market
The growing Canadian market consists of both senior unsecured and secured issues, in each case supported by subsidiary and/or parent-level guarantees and generally with a yield upward of 7%. Its growth has been powered by a broad range of sectors. Companies issuing high yield debt in 2010 represented industries ranging from oil and gas to restaurant services, media, transportation and finance. What these issuers had in common was high debt load relative to earnings and cash flow and, as a result, non-investment grade ratings.
Features of a high yield structure
High yield bond covenants – generally incurrence-based and containing call protections but absent financial maintenance covenants – are looser than bank loan covenants but tighter than those governing investment grade debt. This structure provides companies with the flexibility required to operate their businesses and support growth, while protecting investors from the higher risk associated with speculative debt. However, unlike bank loans under which the issuer is able to renegotiate terms with a discrete group of lenders throughout the life of the obligation (in response to business, market or economic changes), high yield bond indentures are hardly ever revisited due to the practical challenge of obtaining bondholder consent (even though they do contain provisions that, in theory, allow for modifications and waivers). Because of this practical reality, and particularly given the longer five-to-ten year maturity typical of high yield issues, the preparation of indentures and covenant packages requires careful analysis of the financial condition and growth strategy of the issuer as well as expert negotiation and covenant drafting by counsel experienced in capital markets with a focus on high yield debt.
High yield debt in M&A transactions
In the wake of the credit crisis and rock-bottom interest rates, 2010 Canadian high yield debt activity predominantly drove debt refinancings, facilitating bank debt payoff and bond redemptions. However, as was reported in Stikeman Elliott’s M&A Trends: 11 for ’11 publication, Canada’s M&A market has already seen a number of transactions using high yield debt issues as a financing mechanism, including the acquisition by RTL-Westcan Limited Partnership of ECL Transportation Limited. We expect the market to increasingly fuel M&A in 2011 as the confidence of buyout firms increases and particularly if, as expected, interest rates remain near historic lows.