Portfolio Positioning for Provincial Bonds

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Adam Ditkofsky. I’m vice-president and portfolio manager with CIBC Asset Management.

Provincial government debt has become a very interesting topic this year. This is largely resulting from weakening credit metrics related to increased deficits and weakening regional economies. But, overall, provincial bonds performed very well in 2020. And despite the challenges, they’ve retraced about 80% of their widening year to date ending August, with midterm spreads for provincial bonds, which represent the difference in yield between five- to 10-year provincial bonds and Government of Canada bonds of the same term, sitting at roughly 65 basis points at the end of August.

Now, given this spread tightening and the longer-dated nature of provincial bonds — as most provinces tend to focus their issue in the longer-dated bonds so they can lock in long-term funding — provincial bonds have performed fairly nicely with the sector returning 8.7% year to date through the end of August.

This has largely been attributed to ongoing support from the Bank of Canada, which in April announced a $50-billion provincial bond purchase program to provide the provinces with funding support, maintain a lid on spreads and support liquidity. Right after this announcement, we saw provincial spreads quickly tighten with midterm provincial spreads tightening by 35 bps in one week. And this represented almost 75% of their entire recovery this year.

In terms of how the provinces have responded during the pandemic, basically all have announced increased deficits for the fiscal 2020-2021 year. Now they’re all collectively expected to reach a hundred billion dollars, which compares to a deficit of $12 billion last year. Now this is really a reflection of a combination of an increase in spending, but also from significant declines in revenue.

Also, most provinces have removed their targets for when they will return to balanced budgets. So, essentially, all the provinces have seen weakening fundamentals and are running large deficits and have significant borrowing needs.
So, we should really be asking the question, If provincial fundamentals are continuing to weaken, why have they done so well or why did they have such a strong recovery? So, it’s really, again, the support from the Bank of Canada that has driven to recovery in provincial lots this year. And the expectation that the federal government and the Bank of Canada will continue to support the provinces in any way necessary.

In terms of funding, the provinces have collectively raised 60% of their funding needs for this fiscal year. And we’re only more than 40% through the year. But if you account for total refinancing needs for this year. It equates to roughly $150 billion for the entire year. And this works out to an average of $2.8 billion in new provincial debt per week. That’s a material increase from previous years.

Now, fortunately, Ontario, Quebec, and Alberta all maintain well-established international borrowing programs, which over the past five years have basically made up 25 to 35% of their total line of debt issues. And the Bank of Canada still maintains more than $40 billion in capacity under its purchasing program. And we also are of the view that if more capacity is needed, they’d likely step in and increase that capacity.

In terms of which provinces are better off than others — well, Ontario and Quebec tend to have the most liquidity in the market given the scale of their programs. So their bonds tend to be more liquid than other provinces.

Now, provinces with more commodity exposure, such as Alberta and Newfoundland, definitely have more risk to their financial budgets. But given the expected federal support, spreads have remained fairly stable in recent months. Newfoundland fundamentals are weaker than the others with a deficit-to-GDP of 7% and net debt-to-GDP in excess of 50%. And while their ratings are at risk of downgrade, we don’t see risk of a default, as the federal government would likely step in.

And you’re also being compensated for the risk, with relative spreads versus Ontario in the long end, being more than 65 basis points.

Now, in terms of our positioning, we are underweight provincial bonds in an effort to increase our overweight in corporate. While we do expect provincial bonds to outperform Government of Canada bonds over the next 12 months given their excess spread and carry, we maintain the view that corporate bonds will be the winner over the horizon.

Now, in terms of our positioning, it doesn’t necessarily mean we don’t have any provincial bonds. We still have a position in provincial bonds but with a focus in the longer-dated issues, with our largest exposures being in Ontario and Quebec given their liquidity. But we also have overweight positions in Saskatchewan and Alberta, which despite their commodity exposure maintain solid balance sheets with low net debt-to-GDP, both being less than 20%. And this is compared to other provinces such as Ontario, which is about 40%.