Detroit’s US$18-billion municipal bankruptcy, filed on July 18, has left the U.S. municipal bonds (a.k.a. munis) market in tatters. In comparison, Canada’s munis – which represent a tiny slice of the broad Canadian bond market and are seldom traded but pay more than provincial bonds – have had no defaults since the Great Depression. Thus, Canadian munis are sound investments, so long as your clients don’t sell them before maturity.
In Canada, munis are on the same tax footing as other government bonds in that the interest they generate is taxed as income. But munis are not backed by the federal government’s power to create money to pay bills, nor by the large tax bases and federal revenue-sharing of the provinces. Moreover, most Canadian munis lack both visibility and an active aftermarket.
In contrast, U.S. munis give investors a tax break, exempting the interest on the bonds from both federal income taxes and taxation by the state of issue. This tax break has created a huge market and demand for U.S. munis. American investors eager to lower their taxes often buy munis without looking too closely at their underlying fundamentals. As a result, the market has ballooned, creating a flow of funds for municipal governments that have not always been able to repay their obligations.
The local limitation of the tax base is a problem for issuers and a concern for investors, but the Canadian bond market has priced in this risk. For example a Trois-Rivières, Que., muni with a 4% coupon due Oct. 4, 2021, was recently priced to yield 3.8% to maturity. A comparable Quebec provincial bond, the 4.25% issue due Dec. 1, 2021, was recently priced to yield 3.45% to maturity, and the 3.25% Government of Canada issue due June 1, 2021, was recently priced to yield 2.52% to maturity.
Canada’s municipalities have a good record of paying their bond interest on time. The most recent Canadian municipal bond default that New York-based Standard & Poor’s Financial Services LLC (S&P) tracked was in 1935.
Today, provincial statutes for municipal finance tend to make the issuing municipalities financially prudent and conservative, notes Steve Ogilvie, director of ratings with S&P in Toronto. In provinces that have agencies for municipal finance, such as British Columbia, municipal bond proposals tend to be reviewed by senior authorities before the munis are issued.
Canadian municipal finance is a very small market compared with that of the U.S. Most Canadian issuers are in Quebec; but large cities such as Calgary, Edmonton, Toronto and Montreal use munis to raise cash for infrastructure projects. Toronto-based DBRS Ltd. rates all these large cities as AA or higher – except for Montreal, which gets an A (high) rating.
This makes Canadian munis attractive to clients, although they should take care to buy into large issues. “We buy liquid issues of municipalities rated A and above,” says Rémi Roger, head of fixed-income and vice president with Seamark Asset Management Ltd. in Halifax. “We want an issue of $100 million for liquidity if we need to sell. And we don’t go over 10 years maturity.”
There is no question that the big cities that DBRS rates can pay their bills for now. But big cities have a lurking risk in their pension plans, which are the future obligations based on estimates of what retiring employees may receive through funding formulas that typically average a few final years of total pay and multiply that number by years of service.
Thus a 25-year-old civic employee earning $60,000 today and receiving 2% annual pay increases for 40 years to age 65 would have final salary of $132,500 and a pension of $106,000 a year. City taxes, which are based for the most part on real estate values, would tend to rise at the same time, with inflation offsetting some of the future burden of the rising pensions. Still, pension risk is present and unavoidable.
Nevertheless, the Canadian municipal finance market is stable, explains Michael Yake, assistant vice president with New York-based Moody’s Investors Service Inc.‘s subsovereign rating team in Toronto: “We look 10 years ahead. We still have ‘stable’ outlooks for 15 of the cities and regions we rate. We look at the current amount of contributions to pension plans based on today’s revenue, at 2.2% of total revenue. The municipalities we rate – mostly large cities and Ontario municipal regions such as Peel and Halton – have ratings from AAA to AA2.”
Moody’s assumes a rate of return on pension fund investments of 5%-6.5%. These rates have been lowered over the past few years, Yake notes, but the estimate still is conservative: “We look at the intrinsic creditworthiness of an entity and we examine a separate probability that the province would step in if the lower entity requires it. We assign a high level of probability to that. For, without too much trouble, a province could accelerate payment of funds to a city or region, [because the funds] have already been committed.”
Thus, Canadian munis get higher ratings than most corporate bonds, notes Nigel Roberts, president of Bluenose Investment Management Inc. in Lake Country, B.C.: “If you buy these bonds, you can get better quality for a lower cost than in most provincial issues.”
However, there remains the problem of lack of transparency. Municipalities do not have the same level of detailed financial data disclosure that can be found in any public company’s annual and quarterly reports. Credit-rating agencies do not follow the issues of smaller cities. And without the comfort of ratings on smaller cities, potential buyers tend to shy away. Thus, munis can become orphans, still paying interest but with little chance of being sold before maturity.
“We prefer to buy baskets of bonds for our clients,” says Adrian Mastracci, president of KCM Wealth Management Inc. in Vancouver. “We prefer the transparency of corporate bonds backed by standardized financial reporting, the higher liquidity of big-name corporate bonds and the availability of corporate bonds in ladders, in floating-rate issues and, certainly, in liquidity.”
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