Nortel, CanWest remind investors of credit risk

It’s been a long time coming, but Nortel Networks has finally filed for bankruptcy, marking the end of a long dismal slide into investment oblivion. At one point, the company made up roughly one third of the S&P/TSX Composite index.

Its shares, once worth more than $120 are now essentially worthless, trading at about 13 cents, even after a 10-to-1 stock consolidation.

The telecom giant filed for court protection to avoid making a $107 million interest payment on its corporate debt. It’s not the only major Canadian corporation struggling with its debt load: CanWest Global Communications has warned that it may be in breach of its debt covenants.

In an environment where equity returns have been abysmal, many investors sought safety in the fixed income market. With government bond yields at historic lows, the more adventurous investor may have tried to pad returns with higher yielding corporate debt.

“Generally speaking, I like that trade of rotating out of government bonds and into credit,” says Tristan Sones, co-manager of AGF Canadian High Yield Bond Fund, which has just under 40% of assets in corporate bonds. Of course, he cautions that investors need to be conscious of their risk tolerance and consider what they already hold in their portfolio.

But the weakening global economy is now threatening to drive credit default rates higher.

“The market knows we are going to see defaults. What it comes down to is your assessment of what recovery values are going to be on a broad basis. Historically, for high yield, it’s been about 30 cents on the dollar, roughly.”

He says the market appears to be pricing in an even lower recovery rate. When a company is in default, it will typically sell assets to make its debt payments. Right now, most potential buyers for those assets are tightening their own belts, or may not be able to secure funding to make the purchase.

“Recovery levels are going to be lower than where they historically had been,” he says. “Over this year, we’re definitely going to see defaults go up. Some of them will be more high profile than others, and some the bonds are already priced to reflect that, even before the announcement. They’re trading substantially below par already.”

Lately, the global default rate has been running in the low single digits, roughly 4%. Sones says that could double, or even creep into the low teens, but a great deal of that risk is currently priced into the market, especially in the last quarter of 2008, when liquidity dried up.

“That pushed spreads a lot wider. We’ve seen some of that premium come in, because there’s been quite a bit of cash put to work this year,” he says. “Some of the prices have rallied and taken some of that liquidity premium out. Now we’re back to fundamentals, and the fundamentals of the economy don’t look good at all.”

Last year saw essentially flat total returns on corporate bonds, while federal bonds provided low double digit gains. It is almost certain that such huge outperformance will not be repeated, if for no other reason than the fact that government bonds are so highly priced that some are already calling them the new bubble.

“If anything, I think there are more people recognizing where spreads have gotten to, particularly late last year,” he says. “Over the last five or six weeks, there’s definitely been very good flows into the high-yield space in general.”

High-yield issues are highly sensitive to the overall economy, Sones says. During an expansionary phase, companies are usually earning enough to fund their interest payments with ease. In a weakening economy, risk management becomes more of a challenge.

“You’ve got to try and find those sectors that you think will be more defensible, like healthcare and consumer staples — things that are going to be more recession-proof.”

Complicating the corporate fixed-income space are recent government guarantees.

“You really have to know where the different categories stand relative to each other to assess value,” he says. “If one company is now guaranteed and the other is not, that makes a big difference.”

Most attractive are companies that do not really need to come to market with fresh issuance, but are taking advantage of lower interest rates.