Tap Canadian junk bonds

Canadian investors are getting older. According to a Statistics Canada estimate, by 2036 there will be 20 million Canadians over the age of 45, of which 10 million will be older than 65.

These investors are likely to drive up demand for fixed income and stable, structurally senior yield, which is derived from debt that an issuer must repay before other debts if it goes bankrupt.

This has triggered a huge influx of funds into high-yield bonds, or junk bonds, in North America.

According to a recent Moody’s Investors Service report, non-financial speculative-grade Canadian companies raised about $9 billion in the domestic bond market between 2008 and 2010.

Read: Investors should choose Cdn bonds: Moody’s

High-yield bonds generate the same level of return in an investor portfolio as dividend-paying stocks, Paul Tepsich, president and CEO at High Rock Capital Management Inc, told an audience at the second-annual Canadian High-Yield Bond Conference. The main difference: the bonds are backed by legal contracts reflecting debt or purchase obligations, called indentures.

Such bonds are corporate bonds that are typically rated below BBB by S&P, and below Baa by Moody’s. “They offer coupon payments in the range of 7% to 12%, and have five-year to seven-year maturity terms,” he says.

Due to a low correlation to other sectors of the fixed-income market, allocation to high-yield bonds as a separate asset class can also offer some portfolio diversification benefits.

Tepsich asserts adding high-yield debt to a portfolio “increases returns and decreases volatility.”

Read: Why to buy dividend stocks now

Junk bonds, essentially an institutionally traded market, have many barriers as a retail product.

“Most of the bonds offered come via Offering Memorandum [a legal document which contains the objectives, risks and terms of investment involved with a private placement], which is not blessed by the OSC,” he says. “Therefore, you have to be an accredited investor to buy such bonds. The rest must wait for a four-month seasoning period.”

Retail investors must also track the issuing company’s credit reports on an ongoing basis. Further, the bonds’ indentures could be “dry, boring reading.”

Canadian banks have been reluctant to openly promote Canadian dollar-denominated high-yield bonds.

“I’m not sure the Canadian banks know where they stand with regards to legal liability on CAD high yield being jammed through retail investors,” says Tepsich. “Bonds are supposed to mature at par and sometimes they don’t. Banks know where they stand when stocks go to zero, but not when bonds go to zero.”

The Canadian market, despite its relatively small size, inevitably draws comparisons with its counterpart south of the border.

Since 2010, Canadian companies have raised $20 billion in the U.S. market, compared to the staggering US$3.3 trillion raised by American issuers.

And yet, Tepsich prefers and supports CAD-denominated debt issued by local issuers.

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“The buy-Canada theme is very important for the development of our market,” he said. “There’s a very strong buy-Canada theme going on among allocators and investors in the U.S.”

And that’s partly because the Canadian market is safer than U.S. The report from Moody’s Investors Service explains, “Canadian high-yield bond offerings have tighter covenants, which provide more protection for investors than offerings by U.S.-based companies.”

In addition, high-yield, cross-border bonds issued by Canadian companies in U.S. dollars expose investors to greater currency risk than domestic high-yield bonds denominated in Canadian dollars.