Credit quality will be stable in 2004, S&P predicts

(February 4, 2004) Fixed income investors can take heart, as credit quality should remain stable for 2004, according to rating agency Standard & Poors.

“We expect that 2004 will be a period of relative stability for Canadian credit quality,” says Robert Palombi, economist and fixed income analyst at Standard & Poors. “Stabilizing credit quality will favour further tightening in the credit spread, despite an expected rise in bond issuance.”

Since 2001, the credit quality of corporate bonds has been eroding — perhaps not surprising given the poor economic environment. Even less shocking are the sectors which led the erosion: technology, transportation and media — think Nortel, Air Canada and Microcell, just to name a few examples.

“Credit quality has eroded quite severely in some sectors of the Canadian economy and that has led to elevated numbers of downgrades in Canada as well as a record number of defaults,” he says.

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Credit quality erosion occurred mostly at the bottom, with investment grade bonds averaging a rating cut of only one or two grades. In 2002, the average downgraded firm lost three grade points, while tech sector issuers averaged six.

During the period of erosion, seven of the 12 issuers in the “A” range dropped to “B,” leading some of the more conservative investors to determine they were sub-investment grade.

But this has not hurt issuance, with 2003 posting year over year growth of 37.3%, to a value of $74.7 billion.

And why not? With interest rates at historic lows, issuing debt was a relatively cheap way to raise funding and investors became more risk tolerant. As investors bought into corporate bonds, the credit spread between the average corporate yield and the Canadian long-term bond, tightened by 50 to 75 basis points.

“Corporate bond issuance has been all over the map for the past couple of years,” says Rob Polombi. “You had a spike in bond issuance in 2001, when you had North American central banks easing monetary policy during that period, there was investor reticence to participating in the commercial paper market, you had the global economy going into a slower growth period and that caused a number of borrowers to enter the bond market.”

In 2002, he says the previous year’s spike left borrowers “pre-funded,” resulting in a corresponding drop in bond issuance.

Corporate borrowers have continued to grow since that time, while governments continue to retire debt.

“On average corporate borrowers have been able to fund at 125 basis points below peak interest rate levels in 2002,” says Polombi. “Looking ahead to this year and beyond, we would expect that a rebound in business spending will drive issuance volumes higher.”

He says stabilizing and even improving credit quality will help to maintain the tighter credit spread. But he cautions that corporate leverage positions have been rising compared to those of government bonds.

“If we were to see a dramatic rise in bond yields and fears of a downturn in the global economy, that might make the relative leverage position of corporate borrowers less attractive than government borrowers, so we could see the credit spread widen again.”

And while credit quality is stabilizing, Polombi says this does not necessarily mean ratings will start to improve any time soon.

“Although we’re finally coming out of this period of negative ratings pressure, we’re still not seeing positive ratings momentum,” he says. “There are still a very small percentage of companies that have a positive outlook associated with their rating.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(02/04/04)

Steven Lamb