External demand for Canadian bonds is at risk of faltering, casting doubt on the supply of foreign capital needed to meet Canada's borrowing needs, according to a National Bank Financial report.
The Canadian fixed-income market is exposed to foreign investors like never before, said Warren Lovely, head of public-sector research at National Bank. And with Canada's once-superior economic stature having slouched under the weight of the commodity shock, the appeal of Canadian bonds to global investors could fade, he said.
"If not a full-blown systemic risk, Canada's leverage to foreign portfolio investors is a notable vulnerability for the country's capital markets and debt issuers," he said.
Those issuers, both government and corporate, need to continue to tap into international sources of capital, just as they have since the global financial crisis and ensuing recession, Mr. Lovely said.
Canada became a "beacon of light" in the aftermath of that global shock, with the domestic financial sector having avoided much of the risky lending that imperilled the U.S. financial system and housing market, while a relatively strong domestic economy became the envy of the G7, he said.
Canadian exceptionalism was reinforced when the United States was stripped of its AAA credit rating in 2011 for the first time, and as well by the spread of sovereign debt concerns throughout Europe.
"Since the global financial crisis, Canada has basked in the glow of foreign investor interest," Mr. Lovely said.
Since the end of 2007, the book value of foreign portfolio holdings has risen by $820-billion, or 150 per cent. And while some of that money was funnelled into stocks and money market securities, most of it found refuge in Canadian bonds.
"Foreign investors have increased the value of their Canadian bond holdings faster than Canada's own private-sector investors," Mr. Lovely said. "It wasn't just central banks and sovereign wealth funds on the bid; traditional asset managers, banks, insurers, pension funds and even so-called 'fast money' got in on the action, too."
Canadian bond holdings by non-residents now total $1-trillion, representing one-third of the domestic fixed-income market. And foreign investors now hold 40 per cent of outstanding Government of Canada bonds – a share that has more than doubled since before the financial crisis.
But Canadian fortunes have faded. The Bank of Nova Scotia now expects Canadian GDP to grow by just 1.1 per cent this year, which is the worst of the G7 countries – a group that Canada led in growth just two years ago.
And yet, as the oil crash has spread through the Canadian economy, investor sentiment toward Canadian fixed income has been fairly resilient.
"There is not much in the way of a concerted effort to dump Canada as an investment," said David Tulk, head of global macro strategy at TD Securities.
"Just because the Canadian story is looking less than optimistic, there are still opportunities in the market."
In fact, net international purchases of Canadian bonds rose to $82-billion last year up to the end of November from $63-billion the year prior, according to Statistics Canada.
The Government of Canada retains its top credit rating, Canadian banks are still seen as safer than U.S. banks and provincial borrowers are seen as having a federal backstop, said James Dutkiewicz, chief investment strategist at Sentry Investments.
"There's the opinion that any provincial debt is basically a free ride on Ottawa, that they're never going to let a province go," Mr. Dutkiewicz said.
But demand risks remain tilted to the downside – not just as a result of Canada's economic pressures, but also as global foreign exchange reserves have started to decline, predominantly in China, Mr. Lovely said.
Meanwhile, there is no sign that the supply of new Canadian issuance is set to ease up. Rather, a slowing economic forecast and impending fiscal stimulus suggest increased financing needs at the federal level. Provincially, financing pressures could also see issuance tick up.
"And by the looks of things, Canadian banks remain eager to access funding in key foreign markets," Mr. Lovely said. "Call it incremental supply, if not an outright supply shock."