Provincial bonds are an overlooked source of yield, with spreads sitting at more than double their historical averages, says BCA Research

In a research note, BCA reports that the long-term average 10-year spread for the three largest provincial bond issuers (Ontario, British Colombia and Quebec) before the financial crisis was 40 basis points over Canadian sovereign debt. “However, these spreads are currently about 80-110 basis points, which is unjustified given the favorable fiscal outlook in all provinces,” it says.

The independent research firm notes that the Canadian bond market is unique “in that the non-federal government bond sector is a very large part of the public bond market”. It reports that provincial bonds make up approximately 26% of the $1 trillion dollar value of the domestic Canadian bond market, and 46% of bonds with 10 or more years to maturity.

These issues have fundamental credit characteristics that are similar to sovereign bonds, BCA says, in that the provinces raise revenues through taxes, along with transfers from the federal government. “Moreover, provincial debt is highly rated (most debt is A+ or better according to S&P), rating outlooks are stable, liquidity is ample and bid/ask spreads tight,” it says.

While Canada has suffered less, and recovered more quickly, than the United States has, from the recession, BCA notes that there is also a commodity tailwind for provincial government revenues, particularly in the western provinces. “Deficits have increased from generally healthy levels, but not alarmingly so and the outlook for consolidation is favorable,” it also observes.

“The implication is that spreads in the 10-year area have more potential to narrow. Patient investors will be well rewarded by the attractive carry while waiting for spreads to narrow,” BCA concludes.

IE