The $11.8 trillion U.S. corporate borrowing binge will carry on.  With the Federal Reserve leaving interest rates near zero, underwriters, fund managers and credit strategists are all preparing for companies to resume their unprecedented pace of debt offerings.  The Fed’s interest-rate policy, along with a stimulus program that pumped unprecedented amounts of cash into the financial system, kept bond yields so low for so long that companies have been borrowing for just about everything: funding acquisitions, buying back shares, refinancing higher-cost debt and avoiding the need to tap overseas cash that would be subject to repatriation taxes.  The scope of borrowing has stoked concern that companies have become overleveraged.  Junk-rated oil and gas producers and miners that levered up to fund operations are now struggling to refinance amid a commodities slump.  That pushed average yields on all U.S. corporate bonds to the highest in two years last month.  But the extra yield and a Fed that’s on hold for longer are giving debt investors reason to come back for more.  Every new issue this year has lost money so investors now want concessions.  The extra yield that bondholders demand to own Canadian corporate borrowings rather than government obligations ballooned.  It’s the biggest monthly jump since May 2012, and the fattest spread since September 2012.  Corporate yields, the rates companies actually pay to borrow, are still near record lows.  Yet, the widening yield gap over federal debt shows it’s getting more costly to entice investors to take on the added risk of lending to a company rather than the government.  Increasing credit spreads and higher default rates on corporate bonds have preceded most bear markets in stocks in the past and are another reason why we remain cautious on the outlook and have a very defensive investment strategy.

Warning Signs from Corporate Debt Sector

Finally this month we have to look at a pattern that has occurred in the Canadian stock market’s key index, the S&P/TSX Composite Index, that has given rise to an ‘easy rule’ that would have made substantial gains over the past 20 years:  Sell (or even go short) any non-financial stock that becomes the heaviest weighting on the TSX Index.  Here is the history of those trades:  At the height of the technology boom, Nortel overtook Royal Bank with the largest TSX Composite index weight on Aug 21, 1998, on its way to a record setting weight of over 35% of the index in the year 2000 (leaving many managers reporting their returns based on the TSX index excluding Nortel!).  Nortel eventually went bankrupt following the tech meltdown and ended up being de-listed.

Manulife Financial then had the largest index weight during several periods in 2004 to 2006 following the acquisition of John Hancock in the U.S.  The stock weight of Manulife surpassed Royal Bank in April, 2004, with an index weight of 5.08% versus Royal Bank at 4.93%.  The stock more than doubled over the next two years from $20 to the low $40’s before peaking in late 2007.  The leverage to stock prices, the unsustainable dividend yield and the negative impact of lower interest rates on the capital ratios all helped to bring the stock crashing down by over 75% during the financial crisis, forcing the company to do a massively dilutive equity issue near $10 per share just to maintain regulatory capital levels.  The stock has slowly recovered since then as it focused on core earnings growth, moving the stock back into the Top Ten weights, but a long way from #1.

The next victim was Encana Corporation, the energy giant formed from the merger of Pan Canadian Petroleum and Alberta Energy.  It had the largest index weight briefly in 2005: Sep.19, 2005 (ECA 4.85%, RY 4.76%) to Oct.4, 2005.  The stock peaked in 2008 at over $90 per share but then continued to fall over the next few years (splitting as well into Encana as well as Cenovus Corp.) and fell below $10 per share just two months ago as its ranking in the TSX index fell below the Top 40.

Potash Corp also had the largest index weight at one point in 2008, just as investors were enjoying a bull market in commodities, especially in the agricultural area.  The stock then received an additional boost via an unsolicited hostile takeover offer from Australia’s BHP Billiton.  The bid was blocked by the Canadian government for not meeting its criteria of ‘net benefit’ to Canadians.  The stock peaked at over $80 per share and then lost all of those gains as the commodity cycle ground to a halt.  Although it did rally back up to above $60 from 2009 to 2011, the downtrend came back as Potash prices slid and the stock was trading below $30 over the last quarter, and its index rank fell down to the #20 spot.

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