CP Rail’s Higher Leverage Puts Pressure on Risk Spreads

Risk spreads on Canadian Pacific Railway Ltd.’s bonds are widening because the company’s plan to buy Kansas City Southern for $25 billion will push up debt ratios.

CP expects to have $20.2 billion of debt outstanding after the deal, which it will pay for with a combination of shares, cash on hand and $8.6 billion in new debt financing. It’s assuming $3.8 billion of KCS obligations, CP said in a statement Sunday.

As a result, CP expects the combined company’s leverage ratio will rise to around 4 times from CP’s previous range of 2 to 2.5 times that was reiterated in the latest quarterly earnings. It’s aiming to return leverage to about 2.5 times within 36 months after closing a key portion of the transaction.

“The proposed acquisition will materially increase CP’s leverage in the short term and could pose a headwind to credit quality,” said S&P Global Ratings analyst Jarrett Bilous in a statement Monday. “However, we expect steady deleveraging over the next several years from earnings growth and free cash flow generation. In addition, the completion of the transaction should strengthen CP’s business risk profile notably.”

The deal creates the only network that cuts through the three biggest North American countries, giving CP access to the Kansas City, Missouri-based company’s sprawling Midwestern rail system that connects farms in Kansas and Missouri to ports along the Gulf of Mexico.

Interest Rate

It’s a “solid business, but more shareholder-friendly than bond-friendly,” said Mark Carpani, head of fixed income at Ridgewood Capital Asset Management Inc., who expects Canadian Pacific bond spreads to widen Monday.

Canadian Pacific’s $500 million of 2.05% bonds due 2030 were quoted at a spread over Treasuries of about 76 basis points, compared with 68 basis points Friday, according to Trace.

The combined company’s interest rate on its debt will be 3.25% to 3.5%, investors were told in a Sunday conference call. As a reference, the all-in yield of the Bloomberg Barclays U.S. Aggregate: Baa Index, which tracks debt with the lowest investment-grade ratings, was at 2.6% Friday.

CP’s senior unsecured bonds are rated by Moody’s Investors Service at Baa1, its third-lowest investment grade, and an equivalent BBB+ by S&P, which said Monday the company’s rating and outlook are unaffected.

Bank of Montreal and Goldman Sachs Group Inc. have committed to an $8.6 billion bridge loan, which is expected to be syndicated, Bloomberg reported Sunday.

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