TAX NEWS - JUNE 2010

Canada Tax: High-Yield Bonds May Become Option

by Monica Gutschi, 03 June 2010 -- With the scheduled demise of the Canadian income-trust market in 2011, there's a good chance speculative-grade bonds from domestic issuers may be the vehicle to fill the gap.

"On the investor side, we've got investors looking for a place to put their money, while on the issuer side, companies will be looking to lever up their balance sheet," says Ed Sustar, a senior analyst in the Toronto office of Moody's Investors Services.

He say the speculative-grade bond market in Canada is undergoing a revival after more than a decade of languishing, and is likely to pick up even more as income trusts continue to convert back to corporations. These bonds, while riskier than investment-grade paper, will avoid the currency-conversion issues that face investors who purchase high-yield U.S. bonds.

In a recent report, he notes there has been a "significant increase" in the number of speculative-grade issuers raising capital in Canada. Over the past 12 months, eight such companies have issued bonds, raising C$1.7 billion.

While that is a fraction of the US$10 billion in high-yield bonds issued by Canadian companies in the U.S. during 2009, Sustar notes they're the first issues seen since the late 1990s. Canadian companies issued US$20 billion of investment-grade bonds in the U.S. last year.

The high-yield market is poised to open further, Sustar believes. Income trusts will lose their favorable tax status at the end of the year, and he predicts some Canadian investors will look to domestic high-yield bonds as a replacement. "This search for yield is exacerbated in the current low-rate environment," the report notes.

Furthermore, income trusts that convert back to corporations will likely sell debt to reduce their new tax burden. Since many of the operating companies that are currently in income-trust form are relatively small, Sustar believes they're unlikely to go to the U.S. market. "They have an incentive to lever up a bit," he says of their change in status. "If this market does take off and is sustainable, it will be a great place for them to go and raise Canadian dollar-denominated debt."

Additionally, Sustar notes that US$30 billion in speculative-grade Canadian debt will come due over the next five years. Many of the companies may issue in Canada rather than reissue in the U.S.

He points to Cascades Inc. (CAS.T). which sold C$250 million in debt domestically last year, and more than US$750 million in the U.S. at the same time, with the same terms and same covenants. "We believe more Canadian companies will do that as well," Sustar says.

He believes institutional and accredited investors will be attracted to the high-yield market, as will bond portfolio managers who currently purchase such securities in the U.S.

But those high yields don't come without risk. The default rate for investment-grade Canadian corporate debt is only 0.9% over five years, his report shows, but is 23.5% for speculative-grade bonds.

"You need to be selective," Sustar says, and "stay on top" of the issues the companies might face. As well, he notes a big problem with speculative-grade companies is their lack of liquidity.