The Bank of Canada (BoC) announced an additional rate hike of 25 basis points on June 7, bringing the overnight rate up to 4.75%. This news came as somewhat of a shock to the bond market, which reacted by boosting Government of Canada bond yields up across the curve, with 2-year bond yields reaching a new high for this hiking cycle. This magnitude of market reaction, although widely unheard of over the previous decade, has become a staple in the bond market since the start of the BoC rate hikes in March 2022.
While higher yields mean that we can lock in fixed income instruments at higher coupons, it also creates risks for businesses by increasing their cost of debt. With numerous ground-breaking rate hikes and bond yields moving drastically higher and lower more frequently, it is important to rely on fundamentals to see us through these times of volatility.
The key to QV’s fixed income strategies is ensuring our portfolios consist of resilient credits that can withstand these changing market dynamics, while providing stable and reliable returns throughout. As market conditions continue to change, we take a step back to analyze what factors we believe create an enduring credit that we can have confidence in over the cycle.
ABLE AND WILLING
What I have learned during my short tenure on QV’s fixed income team is there are two factors that are fundamental to the credit quality of a corporate bond: ability and willingness. It is one thing for a business to have the ability to maintain their credit rating and balance sheet strength; it is another for management teams to be willing to do this.
Ability reflects the capacity of a company to pay its debtholders and maintain its credit rating. The most important component is the cash flows that are available to pay each dollar of debt as it comes due. Despite any level of willingness from management, lack of cash flows to pay debt will result in a negative credit event. In the same way, a company that would like to maintain their credit rating without the appropriate cash flow to debt ratios will not be able to sustain their credit rating.
A company can have the ability to maintain its leverage ratios and fulfill its debt obligations; however, without dedication from its management team to direct cash flows to these uses, its credit quality will suffer. No level of cash flows can tell us about a management team’s willingness to uphold credit quality, which makes this factor much more difficult to observe.
We must then rely on qualitative elements to glean insights into a management team’s willingness. To do this we look to the past to see what actions they have taken to preserve credit quality, as well as what promises to debt holders have been delivered on.
These two factors must be in alignment with one another at the foundation of any good quality corporate bond. It takes cooperation between the quantitative “ability” and the qualitative “willingness” that, when working together, are signs of a bond with a solid foundation and well laid path to maintaining credit quality.
BCE – A NEAR DECADE LONG DEMONSTRATION OF CREDIT QUALITY
These factors defining credit quality have been at the forefront of our thinking for years. BCE Inc. (BCE), Canada’s largest communications company, remains a lasting example of striking the right balance between the attributes that we look for in a credit, as it has proven over the years since our first letter on this topic.
BCE has made proactive strategic decisions that have positioned them to maintain their credit rating. One of these decisions was to establish their network sharing agreement with TELUS that enables them to share the costs of investing in competitive 5G infrastructure. Limiting these costs has allowed BCE to keep leverage close to the limit prescribed by debt rating agencies, measured by their net debt/EBITDA level.
Sources: Capital IQ, QV Investors
While BCE has recently drifted to the upward bound of this limit, as seen in the above chart, they have done so in a steady and measured manner through these investments in 5G. This is expected to pay off with cost savings and increased cash flow down the road, which is seen positively by debt rating agencies.
We believe that BCE’s proactive strategic thinking has helped them become Canada’s highest rated incumbent telecommunications company.
In addition, over the past 7 years, we’ve seen BCE’s management team continue to develop a strong track record of doing what they say they will do. In 2008, under George Cope as CEO, he and his team dedicated themselves to make BCE a known dividend grower. Since this commitment was made, BCE has grown its dividend by 5% or higher each year.
Sources: Capital IQ, QV Investors
This commitment continued with Mirko Bibic as CEO since George Cope’s retirement in 2020. Despite management changes, this team has shown their willingness to follow through with their goals. This extends to BCE’s commitment to uphold an investment grade credit rating for their bonds over time.
We can’t control what happens in the markets, but we can control how we choose to build our portfolios. By seeking corporate bonds with management teams that demonstrate an ability and willingness to uphold credit quality, we can bolster resilience in our portfolios, making us better prepared to weather market volatility and uncertainty.