1. By – Kartikay Khetarpal
773

2.  The corporate bond market is an important
conduit between savings and investments,
enabling borrowers to issue publicly traded
debt instruments to finance investment
projects and/or spending for general corporate
purposes.
 The Canadian corporate bond market has
become more active in recent years, against a
background of low inflation, reduced public
sector borrowing, and low long-term interest
rates.

3.  In 1998, net new issues of corporate bonds in
Canada exceeded long-term debt issues by the
various levels of government for the first time
since 1973.
 This increased level of activity has been
accompanied by the development of new
products and greater investor interest in
instruments with higher returns and higher
credit risk.

4.  While corporate credit spreads appear to peak
in periods of weak economic activity, shorter
term fluctuations often reflect changes
investors’ preferences for highly liquid
securities.
 A more dynamic Canadian corporate bond
market is a welcome development. It offers
borrowers an alternative source of
funds, especially firms that have typically
relied on the banks and the U.S. bond market.

5.  The close proximity of the U.S. corporate bond
market has contributed considerably to the
development of the Canadian market. Most of the U.S.
market’s structures, practices, and institutional
arrangements have been replicated in Canada. As a
result, the market for bonds issued by non-financial
corporations in Canada is relatively large by
international standards.
 Despite the presence of a domestic corporate bond
market, Canadian borrowers regularly raise funds
outside of Canada, primarily in the United States. This
has been particularly advantageous for borrowers
with weaker credit ratings, since the United States has
a much more developed market for bonds with higher
credit risk.

6.  It is also worth noting that the recent increase in
activity in the Canadian corporate bond market
has taken place in a period marked by a striking
decline in public sector borrowing. In 1998, for
the first time in more than 25 years, the private
sector issued more bonds on a net basis in
Canada than the public sector. This situation is
likely to persist in coming years, given the
improvement in public sector finances.

7.  Until very recently, private sector issuers of
bonds in the Canadian corporate bond market
were mainly well known, highly rated domestic
entities such as financial institutions, utilities,
and the largest industrial companies with credit
ratings of single A or better.
 Financial institutions have been active issuers of
bonds in Canada in recent years. An important
reason for this is that Canadian regulators
include debentures in the definition of a
deposit-taking institution’s Tier 2 capital base.

8.  The development of a high-yield market in
Canada is particularly encouraging, since it
might offer an alternative source of domestic
funds for small and medium sized firms that
have typically relied on the Canadian banking
system and the U.S. corporate bond market
for financing.

9.  Corporate bonds in Canada are held mainly by
institutional investors such as life insurance
companies, pension funds, deposit-taking
institutions, and mutual funds. Life insurance
companies have traditionally been the largest
holders of corporate bonds
 Deposit-taking institutions and mutual funds have
become major buyers of corporate bonds.
 Since corporate bonds are mainly a buy-and-hold
investment for most institutional investors,
secondary market activity does not provide much
insight into the inner workings of the market.

10.  Corporate bonds are priced in terms of yield
differences over government bonds of similar
maturities. The yield spread on a corporate bond
compensates the investor for the expected risk of
default and investor preferences for liquidity
(government bonds are more liquid than corporate
bonds).
 Although the market for credit derivatives is in its
infancy, prices in this market generally change very
slowly and in line with fundamental changes in the
underlying asset’s credit quality.
 This suggests that most of the short-term
fluctuations in corporate credit spreads are mainly
associated with changes in investors’ preferences
for highly liquid securities.

11.  With the improvement in Canada’s economic
fundamentals, its corporate bond market
appears to have a promising future. Borrowers
should be able to access a larger pool of
capital domestically. The development of
credit-analysis skills in Canada and more
widespread use of credit derivatives might also
contribute to the market’s development and
may result in more optimal allocation of capital
in the economy.

12.  That said, Canadian companies will likely
continue to issue a significant portion of their
bonds outside Canada because of their need
for foreign currency and the relative ease of
access to the deep and active corporate bond
market in the United States.
 The Canadian corporate bond market has
thus, experienced a renaissance, in recent
years, against a background of low inflation,
reduced public borrowing, and the lowest
levels of long-term interest rates in a
generation.