The Canadian high yield market is mature beyond its years. Since June 2009, when Viterra (Ba1/BB+/BBB) re-opened the market after the credit crisis with a C$300m 2026 bond priced at 8.5%, the market has rapidly expanded.
In the first eight months of 2011, a total of C$3.3bn was issued in the high yield sector in Canada. Although wider volatility closed the markets for the whole of August, the market is set to surpass the C$3.485bn issued in the whole of 2010 for 14 deals. Indeed, with 18 transactions completed by the end of August this year, the market had already matched the number of deals sold in the first 18 months of the market re-opening.
But the growth of Canadas high yield market is not just about size. It is also about the capacity of the sector to take more challenging products from a wider range of names and selling them down to a broader group of investors. And it is in this regard that the sector has excelled.
Part of the reason for the Canadian high yield markets rapid acceleration to maturity is because it has grown up in the shadow of the well established US high yield sector.
"Canada is alongside the largest, deepest, most developed high yield market on the planet, so it makes sense to take a North American approach to the leverage finance business," says Neil Mohammed, managing director and head of Canadian corporate coverage debt capital markets at BMO in Toronto.
Their North American approach means that many Canadian accounts are already familiar with the high yield product from participating in the US market.
"Theyre very sophisticated investors," says Sean St John, co-head and managing director, fixed income and head of debt capital markets at National Bank Financial Markets. "They know credits as well as anybody in the world, and weve been able to structure the Canadian high yield market about US-type structures theyre already used to."
Issuers, investors and dealers can take an integrated approach to the two markets. Canadian investors continue to participate in US trades and there are also signs of strong appetite from US accounts for Canadian high yield paper, although around 95% of high yield transactions are sold into domestic accounts. Some 20% of Videotrons C$300m 6.875% 2021 senior notes in June of this year were sold into US investors. The Quebec-based media company had previously done many deals in the US when it was the only market open to it, but since the opening of the Canadian sector, it has focused on domestic issuance. The Ba1/BB/BB rated company was returning to the Canadian high yield market this year after its inaugural transaction in 2010.
As Canadian high yield investors and issuers dip in and out of the sector in both the US and Canada, the markets have become entangled.
"This is truly a North American market," says Greg Woynarski, managing director and co-head of global credit capital markets at Scotia Capital in Toronto. "There are portfolios on both sides of the border that are a mixture of Canadian and US companies, and some companies are issuing in both currencies. All were doing is changing the currency on some of these transactions because the structures and the pricing are identical to the US market."
Even borrowers that only operate in Canada and require local currency receive plenty of interest from both the private and public markets in the US, and so have to compare the issuance environment in both jurisdictions. Cross-border co-ordination and execution is also increasingly important to drive demand and price tension. Connacher Oil and Gas (Caa2/BB-) did the first dual-currency cross-border transaction of 2011, and found strong demand from investors in both the US and Canada. Demand for its Canadian dollar seven year non-call four tranche was so strong that the line was increased to C$350m. That paper was issued at the same time as a $550m eight year deal in the US market, with the pricing on the two pieces largely in line on a swapped equivalent basis. Even though the large, liquid US piece was available, a number of US investors participated in the Canadian dollar line, and 45% of that piece went to accounts south of the border.
But appetite can also go the other way. Baytex, a B2/BB- rated firm, found in February that there was plenty of demand for a US dollar transaction that was sold exclusively to Canadian investors. More than 20 investors participated in the 10 non-call five year $150m deal, which was priced with a coupon of 6.75%.
Although many Canadian investors and issuers take a holistic approach to the domestic and US markets, the development of the Canadian high yield sector has brought benefits that were not available when US-based transactions were the only option.
"From an issuers perspective, there are a lot of advantages to issuing in Canada," says Woynarski at Scotia Capital. "First, you dont have to do a swap, which can be expensive especially for a lower rated company, and you dont have to worry about becoming a reporting insurer in the US. You can also do smaller deals in Canada, and dont have to do a minimum of $250m or $300m."
This is not to say that the Canadian high yield market does not have the depth to handle larger transactions in April, Ford Credit Canada (Ba2/BB/BB-) issued C$500m of senior unsecured paper, paying a coupon of 4.875% for the three year deal.
But by offering a public financing solution to smaller borrowers, the sector is building a steadily increasing potential issuer pool to maintain the flow of supply. For many Canadian companies that had relied heavily on the bank market for funded debt before the credit crisis, the withdrawal of bank liquidity in 2008 is still fresh in their mind. These names are now much more comfortable to turn their debt out into the bond markets.
"The early part of 2010 was all about educating issuers on the market, but now there is definitely a belief that the market is sustainable," says Simon Paradine, head of leveraged finance and high yield at Scotia Capital. "We have had experience in doing deals for smaller, mid-market companies with Ebitda around C$30m to C$40m."
Inflows from the income trusts
While many Canadian high yield deals are bought by those investors that have traditionally participated in the market in the US, there is growing interest from new accounts looking at the sector too. The growth of the market over the last year especially has partly been due to investors moving away from the now defunct income trust product.
At the end of September 30, 2010, there were 143 income trusts with a value of C$137bn listed on the Toronto stock exchange, but since the tax on the trusts that had been announced in October 2006 kicked in on December 31 last year, that capital has had to find a new home.
"The income trusts were an important source of yield for Canadian investors, and when they were removed investors lost a significant stream of income," says Rob Brown, a director in debt capital markets at Royal Bank of Canada. "The high yield market represents a good alternative."
The technical bid for yield in the Canadian market partly due to the demise of the income trust product and partly due to an ageing population feeling a natural pull towards products with high returns in a low rate environment has meant that the investor base in the Canadian market has swelled over the last year.
It is estimated that there are between C$20bn-C$30bn of assets under management directed at the high yield product in Canada. But while there has been impressive growth in the investor pool over the last two years, the presence Canadian buyers that have long been active in the US market means that an increasingly wide range of transactions are viable in the market.
Investors are becoming increasingly comfortable with lower or unrated paper. Since mid-2009, four unrated borrowers have tapped the market for around C$662m, deals that would have been inconceivable even back in the tightest credit markets in 2007. For example, in April unrated start-up mobile phone provider Mobilicity priced C$195m of 2029 paper at 9.5%, at the same time as a C$20m subordinated note. Some 18 investors participated in the deal, the second unrated transaction seen in the market.
"If investors are confident that there isnt too much headline risk and that the stability is there, they can start looking at the actual credits, the spread pick-up and the usual things they want to look at," says Richard Sibthorpe, head of DCM syndicate at Bank of Montreal in Toronto. "With such low absolute rates were going to have investors forced either to look further afield to get incremental yield, or move further out the credit spectrum."
The Canadian market has now proved itself to be deep enough to absorb several transactions over a short period of time: in the second quarter of the year alone there were nine deals totalling C$1.662bn. The market has also matured to allow for repeat issuers in the sector. Ford Credit, the largest Canadian dollar high yield issuer having sold more than C$1bn bonds since 2009, was the first name to return to the market in March, while other borrowers have increased the size of existing transactions with add-on deals. Paramount (Caa1/B+) was the first to tap an outstanding deal, adding C$70m to its 8.25% 2017 notes in January, and in May Garda (B2/B) followed by increasing its 9.75% 2017 senior notes by C$50m. Paramounts transaction also marked the first drive-by deal seen in the market, with the transaction announced and priced on the same day.
Investors have also become more comfortable with borrowers using the funding for a wider range of purposes, including dividend recaps, and the potential is there to open the market up to even more of corporations financing needs.
"Most transactions have been refinancings, and so the evolution of more M&A related deals is something we look forward to," says Paradine from Scotia. "We havent seen a pure Canadian dollar financed LBO, and everyones ready to do it. Its just a matter of time."
Market participants across the Canadian high yield market have been reassured by the breadth of facilities that have successfully been completed there. Investors have dealt with PIK toggle structures, deals with warrants attached and unrated borrowers with small market caps. They are confident that they have not, as yet, identified any boundaries that can limit the sector.
"I think the Canadian markets got a deep and sophisticated enough investor base that, given the right story and the right structure, the market is open to whatever we come up with," says St John.
This appetite for Canadian high yield paper is not only felt in primary market transactions, but investors are increasingly looking to trade paper in the aftermarkets too.
"Weve seen a lot of cross-over or equity-oriented investors participating in retail in the secondary market," says Sibthorpe of BMO. "The demand from investors is there, along with supply from an issuer perspective, so all the ingredients are there to make for a healthy, growing market,"
Many dealers in the region have been increasing their teams to develop their trading capabilities, although the secondary market is yet to reach its full potential. This is partly due to the nature of the transactions that have already come through the primary markets."We need to see some bigger transactions in the market to act as more liquid benchmarks for secondary desks and for investors to trade and measure," says Susan Rimmer, managing director and head of debt capital markets, corporate and financials at CIBC in Toronto. "Weve got the breadth of investors and the trading capaibility amongst the Canadian dealers to support those transactions when they come."
An important role to play
Though supply has slowed to a halt over summer, bankers in the Canadian high yield space are confident that the final quarter of the year will bring another spate of issuance. Indeed, August has been only the sixth month since June 2009 in which there has been no issuance in the market.
"In all primary markets, new issues dry up when there are high periods of volatility," says Scotias Woynarski. "As soon as the markets stabilise a little bit, I think were going to find that a lot of people have been waiting."
It is not yet clear how large the high yield market in Canada can grow, as the sectors capacity has yet to be tested in any meaningful way. But from the re-opening back in 2009, there is now a sense that the Canadian high yield market has established a strong foothold and will continue to be a reliable source of financing for Canadas corporations.
"This market will continue to play an important role in the capital markets," says Rob Brown at RBC. "Even in a rising rate environment, investors will recognise the risk-adjusted return benefits of the high yield market and commit capital to the asset class. We built this market from scratch and expect issuance to reach C$5bn-C$7bn in the coming years if conditions prove favourable."