Canadian provincial bonds are a significant part of the fixed-income market in this country. They constitute 30% of the broad FTSE TMX (formerly known as DEX) Index. As comparison, Government of Canada’s (GoC) debt is 25% of the same index. In Canada, similar to Australia or China, a substantial amount of the public debt resides with the provinces. At Signature, we have substantial investments in the debt of Canadian provinces and use Canadian provincial bonds opportunistically to earn additional income for our clients.
This blog post has two parts: Part 1 explains our structural view of the provincial asset class, our current cyclical outlook on provincial credit spreads in the context of the global bond market, and the recent political developments in Ontario. Part 2 uses examples to demonstrate the significance of portfolio construction and opportunistic trading of the provincial asset class that require dedicated fixed-income resources in terms of analytics, systems and personnel.
Part 1: Our Structural View and the Current Cyclical Outlook
From a long-term structural perspective, provincial bonds are great investments which come with attractive additional yield to GoC bonds. We must also consider that, unlike corporations, provinces ultimately have the power to charge taxes and change regulations, if needed, to be able to pay their obligations. This has been recognized by large pension plans and insurance companies with long-dated liabilities as these investors use long provincial bonds, as a GoC substitute, to hedge their liabilities. Table 1 shows the current additional yield that investors receive by investing in the three largest provinces in Canada.
Table 1 - Provincial Credit Spreads
From a cyclical standpoint, the provincial credit spreads (i.e. additional yield to comparable GoC bonds) are at multi-year lows. This has made some fixed-income investors nervous as provincial spreads continue to narrow along with the rest of the credit universe.
Chart 1 - Historical Provincial Credit Spreads in the Context of Broader Credit Markets
We believe the narrowing of provincial spreads has more room to run. Comparing today's provincial spreads to prior cycles diverts attention from the extraordinary nature of this economic cycle in North America and the rest of the developed world. Global capital markets are truly global in the sense that the policies that Ms. Yellen at the U.S. Federal Reserve Bank (the Fed) implements or the strategies that Mr. Draghi uses at the European Central Bank (ECB), have spillover effects to all fixed-income markets globally.
Last week, Mr. Draghi delivered on the much anticipated monetary easing measures. Looking at the package of measures that ECB has delivered, it is now at the forefront of unconventional policy worldwide. Mr. Draghi has taken the best elements of unconventional policy that have been previously tested in other countries and combined them into an all-encompassing package – negative deposit rates (from Denmark), funding for lending (from the U.K.), unsterilized bond buying, forward guidance and Asset Backed Security (ABS) purchases (from the U.K. and U.S.) as well as the ECB's own LTRO. The consensus has to yet to fully appreciate the global implications of these measures, the spillover effects, and the potency of negative rates in Europe. It is in this global environment that investors should assess the value in provincial credit spreads in Canada. Table 2 is a simplified example of the options facing a global bond investor.
Table 2 - Examples of Yields Available Globally
A bond manager has to decide between an Ontario credit risk at 0.8% additional yield versus a GoC or Spanish credit risk at 1.4% versus German bunds or Spanish credit risk at 0.3% over the GoC. In this context, and in our opinion, Ontario is still good value.
Another issue currently causing nervousness about provincial spreads in Canada is the Ontario elections on June 12. Following the developments on the Ontario budget, the election call, the leaders’ debate, and the most recent reports about the investigation into scandals surrounding the Ontario Liberals, it is clear to us that Ontario bonds, and the rest of the provincial bonds complex, are going to experience volatility. From an investment perspective, this is going to open opportunities to own provincial bonds at attractive prices.
As much as I am sympathetic to Ontario Progressive Conservative leader Mr. Hudak's "lessons learned" from his debt-laden depression-era grandparents and opposition to the province’s spending spree, I cannot see this message resonating as much as it should when interest rates are at historical lows. Spending sprees continue at low interest rates and will not stop until the bond market revolts against spenders (e.g. Portugal, Ireland, Italy, Greece or Spain). For Mr. Hudak's message not to fall on deaf ears, Ontario needs a mini financing crisis, a credit rating downgrade and ultimately higher interest rates. Even though the current spending course is not favourable for bond investors nor is it sustainable, from a public policy perspective, why not borrow at historically low rates at this juncture and build infrastructure in Ontario? This is the environment that developed world central banks including the Bank of Canada have created to reward borrowers at the expense of savers.
Putting aside the risk and volatility of an investigation into the Liberal Party, a new political configuration from the June 12 election other than the minority party (the Liberals) cooperating with another leftist party (the New Democrats), this would be good for Ontario bond investments. If any of the parties wins a majority, there is a better chance for improvement in Ontario finances. If Conservatives win either a minority or become a stronger official opposition, finances should improve. The worst scenario for bond investors is the current configuration where "left minority" throws money at "leftist opposition" in order to continue to govern.
Part 2: Portfolio Construction and Trading of Provincial Bonds
Although our positive structural view on provincial bonds governs our long-term thinking of the asset class, several areas require specialization and devotion of portfolio management resources in fixed-income. These include: constructing a provincial portfolio with the best risk-adjusted return, trading the technicalities of the provincial market and accumulating the asset at issuance.
Chart 2 illustrates our strategy for the long (30-Year) provincial bonds this year using three major provinces as an example. We do invest in all three provinces: Ontario, Quebec, and British Columbia. Earlier this year, elections in Quebec caused a stir in Quebec credit spreads. The assessment of Signature's fixed-income team was that the voices for Quebec's independence, that were behind the widening of spreads (relative to other provinces), could not carry the day and the province would remain an integral part of Canada. As a result, we were buyers of Quebec spreads at the wider spreads, when Quebec bonds were the cheapest. This is an example of the necessity of dedicating resources to trade the asset class based on the provincial budgets and politics as well as flows in the provincial bond market.
Chart 2 - Evolution of Provincial Spreads in 2014
Table 3 shows the return of the three provinces over one year as well as the volatility of that return. Sharpe ratio measures the risk-adjusted return of the three provinces. A strong credit such as the Province of British Columbia has outperformed Ontario and Quebec, in terms of return per unit of credit risk, at the long-end of the curve. This is how we have been positioned in 2014 – we are long (relative to benchmark) British Columbia at the expense of Ontario and Quebec.
The situation is reverse at the short-end (5-Year) part of the curve for the three provinces. In the short-end, Ontario and Quebec provide better return (per unit of risk) relative to British Columbia. Additionally in the front-end, the entire provincial sector competes with Canada Mortgage and Housing Corporation (CMHC) bonds, which are guaranteed by the Government of Canada, and corporate bonds. All of these sectors are fairly liquid and offer compelling risk-adjusted return. This is an example of dedicating resources within a fixed-income team to develop and adjust provincial sector strategy and portfolio construction across different maturities.
Provincial bonds offer great value for fixed-income investing for either Return Driven Investing (RDI) or Liability Driven Investing (LDI) mandates. Portfolio construction, strategy, and trading of the asset class require dedicated resources within the fixed-income team. Also, forming a view on the asset class requires a global multi-asset class view of the investment universe and options.
At Signature, we have the global advantage since we invest in all developed and emerging market bonds across our fixed-income portfolios. We also follow monetary and fiscal policy globally. We have dedicated team members to equity sectors, high yield, investment grade, provincial and government bonds that help us put all asset class’ risk and return in the broader context. Our fixed-income structure and dedicated resources are unique in Canada. In contrast to our counterparts (i.e. sell-side) and peers (i.e. buy-side) that continue to reduce their resources to fixed-income, partially as a result of low yields, we are expanding. We believe flexible, innovative and global fixed-income mandates will play a significant role in our clients’ portfolios in the years to come. Now is the best time to invest and grow with us.