Federal government bonds were the belles of the ball in the fixed-income market from 2009 to 2011. In 2012, it was the turn of investment-grade corporate bonds issued by well-known firms. Now, it may be provincial bonds’ turn; they have been ignored due to the market’s taste for high security and good yields.
Positioning your clients in provincials will give them substantially more yield with no serious default risk if 2013 is the year when provincials take off – as bond market-watchers expect.
Currently, provincial issues are trading with fat spreads over federal debt. For example, a Province of Ontario 4.7% long bond due in June 2037 has recently been priced at $119.96 to yield 3.48% to maturity, which is 108 basis points (bps) over a Government of Canada 5% issue due in June 2037, recently priced at $147.79 to yield 2.4% to maturity. The Ontario bond is rated at AA (low) by Toronto-based DBRS Ltd.
Although your clients can get 500 bps more, on average, from high-yield bonds over federal bonds, provincial bonds have the luxury of being backed by taxing authorities that have robust economic bases.
The customary spread of provincials over federal bonds is 40 bps; in fact, that’s where spreads were in 2007, a year before the worst of the credit crisis hit in late 2008. At worst, in the winter of 2008-09, federal/provincial spreads went to 155 bps. Today, spreads averaging 100 bps are closer to crisis levels – even though there is no doubt that all provinces will be able to pay bondholders on time. Moreover, 2013 is not 2008: there is no liquidity crisis, and the Bank of Canada and the U.S. Federal Reserve Board have shown that they can manage the yield curve.
A CAUSE FOR CONCERN?
Still, anxiety over provincial finances is not monetary paranoia. Investors may have cause to be apprehensive. Says Robert Hogue, senior economist with Toronto-based Royal Bank of Canada: “We expect a slight acceleration of growth, but there has been a downward revision of earlier provincial forecasts. Disruptions to energy production, for example, to Newfoundland and Labrador’s offshore oil production in the Hibernia field, slowing growth in Ontario and disappointments with Quebec’s economy are among the issues of concern.”
In addition, the provinces are carrying a heavier load of total government debt, notes Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: “Fundamentals are driving the federal/provincial bond spreads. Provincial deficits are increasing, and you cannot be absolutely sure that the feds would bail out a province that could not meet its commitments.”
The fear of provincial default is theoretical, not a perception that a province will default soon or, if it even got close, that other provinces and the federal government would not step in to maintain Canada’s high level of respect in the world’s bond markets.
@page_break@DBRS rates the provinces from single A (low) for Prince Edward Island up to AA (low) for Ontario and AAA for Alberta. Still, all provinces will be in deficit in 2012-13 – and Ontario’s $22.1-billion deficit is 41.3% of provincial gross domestic product (GDP). Quebec’s deficit, at $7.9 billion, is 62.2% of its GDP, according to DBRS projections. Thus, it’s no wonder that debt markets fret about how the provinces will pay off their bondholders.
Moreover, international banking regulators have relegated provincials to a kind of second-class status: Basel III allows federal bonds to be included in banks’ capital reserves at 100% of face value, but provincial debt counts at only 95% of face value. Insurance regulators also have set lower reserve values on provincials vs federal bonds.
But, says Rémi Roger, vice president and head of fixed-income for Seamark Asset Management Ltd. in Halifax, the yield discrepancy more than makes up for the balance-sheet valuation issue.
FEAR OF WIDER SPREADS
“Provincial bonds are a good deal right now,” Roger says. “Given that the DEX universe bond index returned 6.21% for corporate bonds in the 12 months ended Nov. 30, 2012, and that provincial bonds returned just 3.38% in the same period, a catch-up is almost inevitable.”
The question is: when will that process begin? The fear of even wider spreads, says Heather Mason-Wood, vice president of Canso Investment Counsel Ltd. in Richmond Hill, Ont., is what’s holding back provincials: “The perception that, driven by worsening provincial finances, spreads could widen further is keeping provincial spreads from closing. But when the economy stabilizes and political concerns moderate, then we could see provincial spreads contract to 70 to 80 bps over federal debt of index duration. But that would not happen before the end of 2013 or early 2014.”
Price appreciation on provincials is a waiting game. Some fund portfolio managers are overweighted in provincials vs the DEX bond universe index. Says Roger: “I would be happy with a 10-bps tightening in the federal/provincial spread” – which could happen in a year. On a long bond, that would translate as a 2%-2.5% price gain. Add that to, say, a 2.5% coupon, then the 4.5%-5% total return would be attractive. This situation also would insulate portfolio values from any decline in yields from investors trading out of corporate bonds and into lagging provincials ready to catch up.
Finally, a move to provincials from corporates would cut default risk. Not only that, but provincials have simpler covenants – with far less legalese – than corporate issues. All of this makes provincials ready for gains in 2013.
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