Jan. 14 (Bloomberg) -- Canadian junk bonds will have another year of above average gains before tumbling as soon as 2012 as interest rates rise and sovereign debt concerns “overwhelm” the market, said Barry Allan, who runs the country’s largest non-bank-owned high-yield bond fund.
“We see one more year of good returns and then the risk rises dramatically,” said Allan, president of Marret Asset Management Inc., which manages C$5.2 billion ($5.3 billion), mostly in high-yield funds.
Allan, 56, favors bonds of stable cash-flow generators such as Corus Entertainment Inc., Videotron Ltee., Teck Resources Ltd. and Baytex Energy Corp. He’s also buying U.S. gaming companies such as Wynn Resorts Ltd.
Concerns that European countries will be unable to service their debts could intensify, which may lead investors to shun risky assets as early as 2012, said Allan, who started Toronto-based Marret a decade ago. Governments may be able to forestall a crisis this year with bailouts of countries such as Ireland, he said.
“At some point, sovereign debt risk will overwhelm the market, though we don’t think it will be a 2011 event,” Allan said in an interview at Bloomberg’s Toronto office. “The debt levels are just unsustainable.”
Canada’s high-yield bonds may return about 6 percent to 7 percent this year, topping gains of about 2 percent to 3 percent for corporate debt, he said.
Decade of Gains
High-yield bonds are coming off 10 straight years of gains, with returns of 22 percent last year and 32 percent in 2009, according to a Bank of America Merrill Lynch index. Marret’s High Yield Strategies fund returned 14 percent in 2010, according to Bloomberg data. The Dynamic High Yield Bond Fund, also managed by Allan, returned 12 percent last year and 23 percent in 2009.
Elsewhere in credit markets, Ontario sold an additional C$50 million in floating-rate notes maturing in October 2015, bringing the total outstanding to C$916 million.
Quebec reoffered C$500 million of its 4.5 percent bonds due in December 2020, Canada’s trade deficit unexpectedly narrowed in November and the country’s statistics agency said the last recession in 2008-09 was less severe than the past two.
The extra yield investors demand to own the debt of Canadian investment-grade corporations rather than the federal government fell to 133 basis points yesterday from 134, according to a Bank of America Merrill Lynch index. The spread was as wide as 154 basis points in June and as tight as 114 in March, according to the index, which tracks 736 bonds with a par value of C$291 billion. Yields were unchanged from the previous day at 3.99 percent.
In the provincial bond market, relative yields remained at 54 basis points yesterday. Yields stayed at 3.4 percent from the day before.
Quebec’s debt was priced to yield 81.5 basis points over benchmarks, bringing the total outstanding to C$5 billion. National Bank Financial led the sale.
Canada’s trade deficit shrank to C$81 million in November and the October deficit was revised to C$1.48 billion from an earlier estimate of C$1.71 billion, Statistics Canada said yesterday in Ottawa. Economists surveyed by Bloomberg predicted a C$2 billion November deficit, according to the median of 21 estimates.
Bank of Canada Governor Mark Carney has said exporters need to regain competitiveness damaged by a rising currency and a global recession by making new investments to boost productivity.
Canada’s recession may have lasted as little as seven months, making it one of the shortest since the Great Depression, though the start and end dates of the contraction are ambiguous, according to Statistics Canada.
Junk Bond Sales
Sales of junk bonds in Canada may set another record this year with as much as C$5 billion in issuance after returns exceeded the rest of the world’s high-yield markets in 2010, Scotia Capital said this month.
So-called junk bonds, which are rated below BBB- by Standard & Poor’s and Baa3 by Moody’s, are less sensitive than government debt to rising interest rates, meaning the high-risk corporate bonds will outperform this year, Allan said.
Allan expects issuance to rise in 2011, led by energy and mining firms, and by former income trusts. The federal government scrapped tax breaks for these high-yield equity securities as of Jan. 1, forcing many companies to tap the junk bond market instead.
“The tax changes were the biggest catalyst for the Canadian high-yield market, along with the overall demand for yield,” said Allan, whose firm is the largest high-yield money manager not owned by Canada’s banks or insurers.
Marret is buying bonds of U.S. gaming companies such as Las Vegas-based Wynn and Borgata Hotel Casino & Spa, which issued lower-risk first mortgage bonds, he said.
“Even though the sector is weak, the structure of the bonds is strong,” because mortgage holders would get paid before other creditors in a default, he said.
Allan is less interested in Canadian financial services companies, which make up more than half the country’s bond market. He said rising interest rates will squeeze margins.
“The big run in the Canadian banks is over,” he said. “Canadian banks are among the best in the world, but it’s a sector that’s going to underperform.”
Allan, who spent six years at Altamira Investment Services before starting Marret, says there are already “troubling warning signs” that the credit crisis in Europe isn’t over. He said the index of sovereign credit default swaps is higher than it was in May, when stocks and bonds tumbled on concerns Greece would default.
Yesterday, Moody’s Investors Service said the U.S., the U.K., France and Germany must control spending on pensions and health care to keep their debt burdens stable over the long term.
As the outlook worsens, Allan plans to increase his “short” positions, betting on declines in bond prices.
“It’s a confidence game and the governments and central banks are doing everything they can to maintain confidence,” Allan said. “But you can’t borrow your way out of debt; you can’t solve a debt crisis by borrowing more.”
To contact the reporter on this story; Matt Walcoff in Toronto at firstname.lastname@example.org.