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(David P. Lewis/Getty Images/iStockphoto)

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Provincial bond ETF: A low-risk route to higher returns Add to ...

Super-safe government of Canada bonds currently yield next to nothing. So what is the yield-hungry but risk-averse retail investor to do?

Toronto-based exchange-traded fund (ETF) purveyor First Asset thinks it has the answer: Provincial government bonds.

First Asset has set up the DEX provincial bond index fund, an ETF designed to capitalize on the fact that the debt of Canada’s provinces yields quite a bit more than similar securities issued by Ottawa.

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“We think it is a good risk/return proposition for investors. They’re getting more yield moving from federal government bonds to provincial bonds,” says Barry Gordon, First Asset’s president and chief executive.

If interest rates were about to move substantially higher, most investors probably wouldn’t considered stretching for extra income by purchasing provincial bonds. But in a low-yield environment that looks likely to persist for years, every little bit of extra yield helps.

Investors can pick up about one full percentage point in extra yield with Ontario 10-year bonds, for instance, compared with government of Canada bonds with a similar maturity. The Ontario 10-year securities yield about 2.9 per cent, the federal bonds around 1.9 per cent, indicating the approach of going with the provincial bond leads to about 50 per cent more income.

Currently, buying provincial bonds to capitalize on the wide yield spread is challenging for retail investors The market is opaque, with brokers typically charging sizable mark-ups hidden in the quoted prices at which they’re willing to buy and sell the securities. This cuts into returns – a challenge that isn’t faced by large institutional purchasers, such as First Asset, that can buy in bulk and get far more competitive pricing from investment dealers.

The DEX fund, which began trading on the Toronto market Monday, has a yield to maturity of 2.8 per cent, and about 85 per cent of the bonds it holds are from Ontario and Quebec. The balance is split almost equally among British Columbia, New Brunswick and Manitoba debt. The five provinces have a range of credit ratings in the double-A and single-A categories.

First Asset charges a management fee of 0.25 percentage point on the DEX ETF.

According to Mr. Gordon, fund companies have overlooked the provincial bond market, with only one other offering, the BMO short-term provincial bond ETF.

Federal debt yields so little in part because it is viewed as the safest, least risky security valued in Canadian funds. It also helps that the Bank of Canada quite literally has a licence to print money. Provinces, with no central banks and historically higher deficits relative to their size than Ottawa, are viewed as less credit-worthy and therefore have to pay more to borrow.

But Mr. Gordon believes the market is mispricing the riskiness of the provinces, which he considers to be in a “too big to fail” category where Ottawa wouldn’t allow a default. If Canada’s financial problems were so extreme that the provinces were going broke, it would also indicate a financial apocalypse that would take down Ottawa too, in his opinion.

“I don’t think the average Canadian thinks that the federal government is going to let any province default on its debt obligations,” he says. “Under what circumstances could you see the provinces of Canada defaulting that the government of Canada wasn’t also in default?”

Mr. Gordon says the provincial debts are a good compromise position for those unwilling to buy junk bonds or accept the risk of owning equities, but still want income.

 
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