Latest / How Canadian Markets Work / Episode 37: Corporate Bonds

Transcript

Episode 37: Corporate Bonds · How Canadian Markets Work

0:00
You know, when a company goes bankrupt, the chaos
0:02
always feels so sudden. Oh, absolutely. Yeah,
0:05
I mean, the headlines flash, the stock price
0:07
plummets, and, you know, the employees are just
0:09
left in the dark. Right. It's a very public spectacle.
0:12
Yeah, it is. But the truth is, who loses everything
0:16
and who gets their money back was actually decided
0:18
years ago, you know, in some quiet room through
0:22
these completely invisible contracts. Yeah, that
0:25
is a really sobering reality, isn't it? Yeah,
0:27
it really is. We tend to focus on the noise of
0:30
the failure, right? The drama of it. But the
0:33
underlying architecture, the legal agreements
0:36
that were drawn up in times of optimism, that
0:38
dictates the final unforgiving outcome. Right.
0:41
And that invisible architecture is exactly what
0:43
we are exploring in this deep dive today. Yeah,
0:45
it's a fascinating topic. It really is. So welcome,
0:49
everyone. Our sources today are a detailed stack
0:52
of financial education scripts, and they're focused
0:55
specifically on Canadian market mechanics. And
0:58
our mission here is to gently decode the hidden
1:03
rules of corporate debt. Right. We want to understand
1:05
what actually happens to your money on a company's
1:08
absolute worst day. Exactly. And, you know, explore
1:11
the contracts that determine who is saved and
1:14
who is just quietly wiped out. And it's a subject
1:17
that truly requires us to, well, to slow down
1:21
and look really closely. Yeah, pick our time
1:23
with it. Because so many people hold corporate
1:25
bonds. I mean, often they're tucked away inside
1:28
mutual funds or, you know, exchange traded. Right,
1:31
in your retirement account or whatever. Exactly.
1:33
And people view them as this cozy blanket of
1:36
safety. They look at their portfolio and think,
1:39
well, it's a bond, so therefore, it is secure.
1:42
Yeah. But today... we are gonna see that a corporate
1:46
bond is not just one uniform thing. No, not at
1:50
all. It's actually a highly specific legally
1:52
binding place in a very long line. Right. Okay,
1:56
so let's unpack this. So before we can really
1:58
understand how lenders try to protect themselves,
2:01
we first have to understand exactly who gets
2:03
paid first when a company fails. Right, who's
2:05
at the front of the line. Exactly. There is this
2:08
strict unyielding priority queue in what we call
2:12
the capital structure. OK. And at the very front
2:14
of that line, sitting close to the exit, you
2:17
have the secured creditors. OK, so secured creditors.
2:19
These would be the lenders with a legal claim
2:22
on a specific physical asset. Yes, exactly. So
2:27
like, for instance, a bank holding a mortgage
2:30
on the company's main manufacturing plant. Right.
2:33
Or maybe a lien on a fleet of delivery vehicles.
2:37
If the company fails, the bank essentially just
2:40
gets the keys to that plan. Yeah. That specific
2:43
collateral is their safety net. They are protected
2:46
by that physical thing. Right. And just behind
2:48
them in the queue are the senior unsecured creditors.
2:51
OK. And in Canadian financial terminology, you
2:54
will very frequently hear these referred to as
2:56
debentures. OK. Let's pause there for a second,
2:58
because financial jargon can easily alienate
3:01
people. Oh, for sure. What? conceptually separates
3:05
a regular bond from a debenture. Like, why do
3:07
we use that specific word in Canada? Yeah, it's
3:10
a really great distinction to make. The word
3:12
debenture actually originates from Latin, essentially
3:15
meaning their due. Oh, interesting. Okay. Yeah.
3:19
So in a broad legal sense, it is simply a document
3:21
acknowledging a debt. Right. But in practical
3:24
Canadian market terms, when we say debenture,
3:26
we are specifically talking about debt that is
3:28
not backed by a physical asset. OK, so no keys
3:32
to the manufacturing plant for them. Exactly.
3:34
There is no warehouse or fleet of trucks pledged
3:38
to these lenders. Instead, the loan is backed
3:41
entirely by the general credit worthiness, the
3:44
cash flow, and the reputation of the issuing
3:46
company. I see. So they don't have a claim on
3:50
a specific building, but they're still quote
3:52
unquote senior. Yes, they are. Which means they
3:55
have a first -ranking claim on whatever is left
3:57
in the general pool of assets after the secured
4:00
lenders take their specific collateral. That
4:02
is exactly the mechanism, yeah. They are first
4:05
in line for the unpledged leftovers, essentially.
4:07
Unpledged leftovers. I like that. OK, so we have
4:11
secured creditors at the absolute front, followed
4:13
by senior unsecured, which are the DaVenture
4:15
holders. Right. We are moving further back in
4:17
the line now. Who sits behind them? Next is subordinated
4:22
debt. OK. And these lenders only get paid after
4:25
the senior unsecured bondholders are entirely
4:28
completely whole. Wow. OK. So not just partially
4:32
whole. No. Completely repaid. Every cent. Right.
4:35
And then behind the subordinated debt are the
4:37
preferred shareholders. And finally, at the very
4:41
back of the line, holding the absolute ultimate
4:43
risk are the common shareholders. Right. The
4:46
people who just bought the stock on an app or
4:47
something. Exactly. Now, if we connect this to
4:50
the bigger picture, This entire queue only matters
4:54
on the absolute worst day of a company's life.
4:56
On a normal sunny Tuesday, everyone gets paid.
5:00
The bondholders receive their fixed interest
5:02
coupons. The shareholders might collect their
5:04
dividends. The line feels completely irrelevant.
5:07
Right. Nobody's thinking about the line on a
5:09
Tuesday. No, not at all. But on that final worst
5:12
day, this queue completely determines your financial
5:15
fate. You know, it makes me think of an engineer.
5:18
drawing a blueprint for a passenger ship. Oh,
5:21
yeah. Right? Like the secured creditors are sitting
5:24
comfortably inside the lifeboats from day one,
5:28
just waiting. Yep. They have their designated
5:30
seats. Exactly. And the senior unsecured lenders
5:33
are lining up on the deck, basically just hoping
5:36
the engineer drew enough seats for them. Right.
5:39
But the subordinated debt and the common shareholders,
5:42
they are standing down in the engine room in
5:45
the dark holding a bucket. Yeah. And the water
5:48
is rising steadily. Exactly. But, you know, I
5:51
have to push back on the setup, though. OK, sure.
5:54
If subordinated bondholders are so far back in
5:56
the line, you know, standing in the water in
5:59
the engine room, why would anyone intentionally
6:01
put themselves in that position? It's a fair
6:03
question. Like, why buy that debt at all? Well,
6:06
to understand that incentive, we need to run
6:08
through the exact fictional scenario that's provided
6:11
in our sources. OK, let's do it. Let us slowly
6:13
walk through the math of a corporate liquidation.
6:17
Imagine a mid -sized company completely fails.
6:20
Every desk, every patent, every piece of machinery
6:23
is sold off. And the total cash remaining in
6:26
the center of the table is $100 million. $100
6:30
million in cash. I am picturing the stack on
6:32
the table right now. Right. Now, let's look at
6:34
the legal claims against that money. We have...
6:37
$40 million in secured debt, which is backed
6:41
by a specific piece of prime commercial real
6:44
estate. We also have $120 million in senior unsecured
6:48
debt. OK, the debanchers. Exactly. And finally,
6:51
we have $60 million in subordinated debt. Right.
6:54
And we will just ignore the shareholders entirely
6:56
for this exercise because their outcome will
6:58
become obvious very shortly. Yeah, doing the
7:01
math in my head. We have $220 million in total
7:05
debt claims, but only $100 million in cash to
7:08
satisfy them. Exactly. There's not enough to
7:10
go around. No. So we simply walk down the legal
7:13
queue. The secured creditors are owed $40 million.
7:17
Let's say their specific commercial property
7:20
is sold off for $45 million. OK. So they take
7:23
their $40 million. Yeah. They are fully repaid,
7:27
sitting in the lifeboat. safely rowing away.
7:30
Exactly. And there's $5 million left over for
7:32
the seal of that building. Right. And that remaining
7:35
$5 million flows straight into the general pool.
7:38
Oh, OK. So we started with $100 million in total
7:41
assets across the company. $40 million went to
7:44
the secured lenders, leaving exactly $60 million
7:48
sitting in the general pool. OK, $60 million
7:50
left. Yes. Next in line, the $120 million in
7:55
senior unsecured debt. But wait. They are owed
7:57
120 million, but there is only 60 million left
8:00
on the table. Exactly. So they take all of it.
8:03
Wow. They receive exactly 50 cents on the dollar.
8:06
It is a 50 % loss on their principal. Oh, man.
8:09
And now the general pool is completely empty.
8:11
Just zero dollars left. Zero. So the legal cube
8:14
moves down to the 60 million dollars in subordinated
8:17
debt. And they receive absolutely nothing. Nothing
8:20
at all. A total devastating wipeout. Preferred
8:23
shares. Zero. Common shares, zero. Wow. Which
8:28
brings me back to my question, though. Yeah?
8:30
If the math is that brutal and the hierarchy
8:33
is that unforgiving, what is the actual tangible
8:36
incentive to take that subordinated risk? The
8:39
incentive is the coupon, the yield. The subordinated
8:43
bondholders might have been collecting just one
8:46
or perhaps 2 % more in interest every year compared
8:49
to the senior bondholders. Wait, really? just
8:51
one or two percent. Yeah. That tiny incremental
8:54
bump in yield was their sole compensation for
8:58
standing down near the engine room. That is wild.
9:00
One or two percent. That is it. Yeah. So over
9:02
a decade, they collected maybe 15 or 20 percent
9:05
extra in income just to lose 100 percent of their
9:08
principal on the worst day. That's the reality.
9:10
They traded a total wipeout for literally pennies.
9:13
They did. Which brings us to the fundamental
9:15
psychology of credit risk. And this requires
9:19
a real profound shift in how we think about investing,
9:23
especially for those of us accustomed to the
9:25
stock market. Right, because stocks are totally
9:27
different. Exactly. When we buy common stocks,
9:30
we are hoping for unlimited upside, right? Yeah,
9:33
the sky's the limit. But credit is a business
9:35
of deep asymmetry. It is built on small, consistent
9:39
gains punctuated by occasional absolute total
9:42
losses. Right. And here's where it gets really
9:44
interesting, because In almost any other area
9:47
of life, if you are right 99 % of the time, you
9:50
are a genius. Oh, absolutely. You win the game.
9:52
But in corporate credit, if you are right 99
9:55
% of the time, and that one mistake is a total
9:58
wipeout of your principal, you could literally
10:01
bankrupt your portfolio. Yes. You are basically
10:03
picking up pennies in front of a steamroller.
10:05
That's a perfect analogy. Your upside is strictly
10:08
legally capped. Think about it this way. If you
10:12
lend a company money, and that company goes on
10:14
to invent a revolutionary new technology or cures
10:17
a disease and its stock price triples in value,
10:21
you do not get a single dollar more than your
10:24
fixed coupon and your principal back. Wow. You
10:27
have traded away all of the upside in exchange
10:29
for the certainty of income. Yeah. But your downside,
10:33
your downside remains total. That's terrifying.
10:36
So how do you survive a game where you can only
10:39
win a little, but you can lose everything? Well,
10:42
diversification. OK. In the credit markets, diversification
10:45
is not a gentle suggestion for a balanced life.
10:48
Right. It is the only mathematical way to survive
10:51
the fundamental asymmetry of the asset class.
10:54
Because, I mean, one default in a portfolio of
10:57
50 bonds, that is an annoyance. Yeah, exactly.
10:59
You lose 2 % of your total portfolio, your other
11:02
coupons continue to pay out, and you easily survive
11:05
to invest another day. Right. But one default
11:08
in a portfolio of three bonds. That is catastrophic.
11:12
It is. And this poses a very specific structural
11:15
challenge for retail investors. Oh, so? Well,
11:18
the sources point out that retail access to individual
11:20
corporate bonds in Canada is generally quite
11:22
poor. Yeah. Unlike the stock market, which operates
11:26
on a highly visible centralized exchange like
11:29
the TSX. Right, where everyone sees the same
11:31
price. Exactly. The bond market is mostly an
11:34
over -the -counter market. It is a network of
11:37
dealers trading directly with each other. OK.
11:39
And when you have dealer networks, you inevitably
11:41
have spreads. Precisely. The spread is the invisible
11:45
fee you pay. It's the difference between the
11:48
buying and selling price. For a massive institutional
11:51
order of $10 million, that spread is razor thin.
11:54
But for a small retail -sized order of $10 ,000,
11:58
those spreads are remarkably wide. The dealer
12:01
takes a much larger cut for the inconvenience
12:04
of a small trade. Ah, I see the trap. So if a
12:07
retail investor tries to build their own portfolio
12:09
of 50 individual corporate bonds just to get
12:12
that necessary mathematical diversification,
12:14
those wide retail spreads will just quietly eat
12:17
their returns alive. They will. Therefore, holding
12:20
corporate credit through mutual funds or ETFs
12:23
isn't just about administrative convenience or,
12:25
you know, saving time. It fundamentally solves
12:28
two massive problems at once. It solves the concentration
12:32
risk and it bypasses the retail spread. That
12:35
makes total sense. Because the fund manager trades
12:38
in massive institutional sizes, securing tight
12:40
pricing, and they hold hundreds of bonds, neutralizing
12:44
the impact of any single worst day wipeout. Okay,
12:48
so the downside is severe. Total wipeout severe.
12:51
Yes. And we know the borrower, the corporate
12:53
management team, is the one actually steering
12:55
the ship. They are. So how do lenders even the
12:58
senior ones at the front of the line, stop the
13:01
borrower from driving the company off a cliff.
13:03
Well, they use contracts. OK. Specifically, they
13:06
use covenants. Covenants are the formal legally
13:09
binding promises a borrower makes about exactly
13:12
how they will behave while they hold the lender's
13:15
money. I want to pause on the necessity of this
13:17
for a second, because it really highlights an
13:20
inherent conflict of interest between the two
13:22
sides of the capital structure. It really does.
13:24
Because once a company has my money, and it is
13:27
locked in at a fixed interest rate, the company
13:29
is actually incentivized to gamble with it. Yes,
13:31
they are. Right. Because if management takes
13:33
a massive reckless risk and it pays off, the
13:37
shareholders get all of that unlimited upside.
13:39
Exactly. But if the gamble fails, the bondholders
13:43
absorb the loss. It is heads they win, tails
13:47
I lose. You have just described the central tension
13:51
of corporate finance. And that is exactly why
13:54
protective covenants exist. A covenant might
13:57
put strict limits on the company taking on any
14:00
additional debt, which prevents them from diluting
14:03
your claim. OK, that's smart. Or it might restrict
14:06
them from paying special dividends or buying
14:08
back shares. Why restrict dividends, though?
14:11
Because every dollar handed out to the shareholders
14:13
is a dollar that cannot be used to pay back the
14:16
creditors. Ah, right. It is essentially a financial
14:18
leash. It is. And what's fascinating here is
14:21
you can look at two different bonds sitting side
14:23
by side on a screen. They have the exact same
14:26
interest rate. They have the exact same credit
14:27
rating from an agency. OK. But they can be entirely
14:31
fundamentally different investments based purely
14:33
on their protective covenants. Meaning the underlying
14:37
legal covenants actually matter significantly
14:39
more than the coupon rate. Far more. A high coupon
14:43
with weak covenants is just a trap waiting to
14:46
spring. Wow. But unfortunately, there is a systemic
14:48
trend working against investors right now in
14:51
the market. Really? What is it? It is known across
14:54
the industry as the covenant -like trend. But
14:57
wait, why would investors ever agree to weaker
14:59
protections? Are they just desperate for yield
15:03
when central banks drop interest rates to zero?
15:05
That is the exact psychological mechanism at
15:08
play. During periods when money is cheap and
15:11
abundant, investors are frantically competing
15:14
for yield. They need returns. The issuers, the
15:17
companies borrowing the money, they recognize
15:20
that the power dynamic has shifted. Ah, they
15:23
hold the leverage. Exactly, they hold the leverage.
15:25
So the companies approach the market and say,
15:27
well, we will pay you the yield you desperately
15:29
want, but we are stripping out the maintenance
15:32
covenants. Oh, man. We want no limits on our
15:34
dividends and no limits on our asset sales. They
15:37
are willingly boarding a ship they know doesn't
15:40
have enough lifeboats just because the ticket
15:42
was a dollar cheaper. That is a perfect way to
15:45
phrase it. Back a while. And this covenant -like
15:47
debt has completely flooded the global debt markets
15:50
over the last decade. Really? Yeah. The average
15:53
protective quality of corporate debt naturally
15:56
varies through the economic cycle, but we have
15:59
lived through a very long historic cycle of weakening
16:04
lender protections. That is deeply unnerving
16:06
to think about. It is. But, okay, let's say I
16:09
am careful. Okay. Let's say I read the documents.
16:12
I buy senior unsecured debt. a proper debenture.
16:15
It has strong traditional covenants. I am at
16:18
the front of the general line. I am safe, aren't
16:21
I? Well, this raises an important question. Who
16:23
exactly are you lending your money to? The company.
16:27
I bought the company's bond. But which specific
16:29
part of the company? Because this introduces
16:32
the hidden trapdoor of the corporate bond world,
16:34
which is structural subordination. Structural
16:37
subordination. OK, walk me through how this trapdoor
16:39
opens. Modern corporations are rarely just a
16:43
single simple entity. Right. They are massive,
16:46
complex, legal family trees. You have a parent
16:49
company at the top. And beneath it, you might
16:51
have dozens of subsidiary companies. Let's dig
16:55
into the why of that for a moment. OK. Like,
16:57
why do companies create these complex webs of
17:00
subsidiaries in the first place? Is it just to
17:02
confuse investors? No, not at all. There are
17:05
very practical business reasons for it. OK. Often,
17:08
it is about operational wind fencing and liability
17:11
shielding. Imagine a large telecommunications
17:15
company. They might put their physical fiber
17:17
optic cables in subsidiary A and their consumer
17:20
retail stores in subsidiary B. If a customer
17:24
slips and falls in a retail store and sues the
17:26
company into oblivion, subsidiary B might go
17:29
bankrupt, but the profitable physical network
17:31
in subsidiary A remains entirely safe and untouched.
17:35
It is also used heavily for tax optimization
17:38
across different international borders. That
17:40
makes perfect sense from a corporate strategy.
17:42
perspective. You just isolate the risks. Exactly.
17:44
But it creates a maze for the bond holder. Suppose
17:47
you lend your money to the parent company at
17:49
the very top of the tree. You hold a senior bond
17:53
issued by that parent. You feel entirely secure.
17:56
I do. I am senior. I check the box on the form.
17:58
But what if all the actual physical operating
18:01
assets, the fiber optic cables, the patents,
18:05
the revenue generating machinery sit down inside
18:07
those subsidiary companies? Wait. The parent
18:10
company might legally just be a filing cabinet,
18:14
a brand name, and a bank account. Well, but the
18:16
parent owns the subsidiary. So by extension,
18:19
the parent owns the assets, right? Yes. But the
18:21
subsidiaries can also borrow money directly from
18:24
their own lenders. Oh, no. And if the whole corporate
18:27
family collapses, the law looks very strictly
18:30
at where the assets physically and legally reside.
18:33
The creditors who lent directly to the subsidiary
18:35
get paid first out of those subsidiary's assets.
18:38
Wait, so the subsidiary's creditors get paid
18:41
first, and only if there is money left over does
18:44
it flow up to the parent company to pay me. That
18:47
is exactly the geographic reality of the law.
18:49
That is incredible. So I can legally hold a senior
18:52
bond, but simply because of where I sit on the
18:56
geographic corporate family tree, I am structurally
18:59
behind someone else. Yes. I am subordinated on
19:03
a geographic technicality. A technicality that
19:05
has cost unwary investors billions of real dollars
19:09
over the years. Wow. The parent company's creditors
19:12
are functionally at the back of the line for
19:14
the subsidiary's assets, no matter what the word
19:17
senior says on their pristine bond certificate.
19:20
That feels like a sleight of hand, even if it's
19:21
perfectly legal. It does. It requires immense
19:24
diligence to navigate. Yeah. with adding a crucial
19:27
nuance from our sources regarding Canadian law
19:30
specifically here. While our mathematical waterfall
19:33
example of the $100 million was clean, real insolvency
19:37
in Canada rarely looks like a simple yard sale.
19:40
It operates under specific federal statutes,
19:43
most notably the company's Creditors Arrangement
19:45
Act, or the CCAA. Okay, so how does the CCAA
19:48
change the outcome? Does it just throw the priority
19:51
queue out the window? No, it doesn't throw the
19:53
queue out, but it changes the arena. How so?
19:56
The CCAA is designed for restructuring, not pure
19:59
liquidation. Oh, OK. When a large company files
20:02
for CCAA protection, the court grants a stay
20:05
of proceedings. Everything pauses. The company
20:09
doesn't immediately sell its buildings. Instead,
20:12
the lenders are effectively locked in a room
20:14
to negotiate a compromise, often forming creditor
20:17
committees. So they're negotiating to keep the
20:20
company alive. Precisely. Creditors might agree
20:24
to take a haircut on their debt, or they might
20:26
swap their debt for equity ownership in the newly
20:28
reorganized Liener company. OK. But, and this
20:32
is the vital connection to our earlier point,
20:34
the priority queue. completely shapes the bargaining
20:38
power inside that room. Ah, I see. Because everyone
20:41
in that room knows what would happen if the negotiations
20:44
fail and it goes to a pure liquidation. Exactly.
20:47
If you hold subordinated debt, you have absolutely
20:49
zero leverage in that negotiation. Because they
20:52
know you'd get nothing anyway. Right. The senior
20:53
lenders can look across the table and say, well,
20:55
accept this tiny fraction of a penny, or we liquidate
20:59
tomorrow and you get mathematically nothing.
21:01
The invisible queue dictates the leverage of
21:04
the visible negotiation. That makes total sense.
21:07
So what does this all mean? Well, it means a
21:10
corporate bond is absolutely not a monolith.
21:13
It is not just a uniform, comforting slice of
21:17
safety that you can ignore once you buy it. Exactly.
21:20
Your actual mathematical safety depends entirely
21:23
on your exact place in that priority queue. It
21:27
depends on the legal strength of the covenants
21:29
you demanded. And it depends heavily on your
21:32
geographic position in the corporate structure.
21:35
And it also means that a slightly higher yield
21:37
is never, ever a free lunch. It is always a trade.
21:41
You are trading certainty for a tiny bit of extra
21:44
income and taking on catastrophic worst day risk
21:48
in return. We really have to remember that when
21:50
we look at our statements. Even if those bonds
21:52
are tucked inside a passive fund, traded by institutions,
21:56
these invisible rules are governing the fate
21:58
of our money every single day. They are. And
22:02
if we think back to that covenant trend trend
22:04
we discussed earlier, this is the thought I would
22:06
really leave you with to mull over. OK, let's
22:08
hear it. If we accept that covenants are the
22:11
only legal guardrails stopping a corporate management
22:14
team from gambling with lenders' money, and we
22:18
know that covenant -light debt has completely
22:20
flooded the global market during the recent desperate
22:23
chase for yield, What actually happens during
22:26
the next massive economic downturn? The guardrails
22:29
aren't there anymore. They aren't. The defaults
22:32
will happen, as they always cyclically do, but
22:35
the recovery rates, the amount of money bondholders
22:39
actually manage to scrape back from that general
22:41
pool, they might look radically terrifyingly
22:45
different than in past recessions. Because there
22:47
were no protections in place. Exactly. We have
22:49
a whole generation of retirees sitting in what
22:51
they firmly believe is quote unquote safe senior
22:54
debt. Yeah. But will we see them wiped out? Simply
22:57
because the invisible legal guardrails were quietly
23:01
legally stripped away years ago. Because when
23:03
the ship finally hits the iceberg and they go
23:06
looking for those lifeboats, they might find
23:08
that someone legally sold the lifeboats five
23:11
years ago to pay a special dividend. That's it
23:13
exactly. The blueprints were fundamentally changed
23:15
and nobody noticed until the water started rushing
23:18
in. A quiet room indeed. We'll check your blueprints
23:21
everyone. Thanks for taking this deep dive with
23:24
us.