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opinion

Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.

Individual investors in Canada tend to focus on Government of Canada bonds when thinking of fixed-income securities for their personal portfolios. U.S. Treasuries, as the world’s benchmark, are also followed, as central government bonds in other developed countries are priced off their American counterparts.

Canada is unique insofar that it is a confederation with 10 provincial governments and three territories. Those provinces generally have more power and responsibility than subordinate governments in other federations. Also, four provinces – B.C., Alberta, Ontario and Quebec – account for 87 per cent of the country’s GDP. Provinces are free to raise taxes, provide programs for their residents, and can issue debt in their own name. Consequently, Canadian provinces have large outstanding debts relative to non-national governments in most other countries.

The good news for investors is that this provides a vibrant provincial debt market which generates higher yields than Government of Canada issues with far less credit risks than corporate bonds.

The provincial bond market is large. The typical Canadian bond index fund or ETF has about one-third of its weight in provincial issues, a bit more than two-fifths of its weight in Government of Canada bonds and the remainder is mostly corporate issues. Provincial issues always yield higher than similar-term federal bonds, mostly to reflect higher perceived credit risk and also for the fact they tend to have less liquidity. Liquidity matters far more to a very large and active manager than to an individual investor. The federal government has a larger tax base than any individual province, which is obvious, but far more importantly, it can create Canadian dollars.

Explainer: What are bonds? How do they work?

There has always been an assumption in the market that if a province was in danger of defaulting on its debt, the federal government would bail it out. No one alive today remembers a time when any province was in danger of defaulting on its obligations. Many alarmists may express worries today. The truth is that governments in most developed and other countries need to address their fiscal debt situations, but no province is in any danger of default and has not been for a very long time. The only province to ever have defaulted was Alberta in 1936, during the depths of the Great Depression. The province had a population of less 800,000 at the time. The federal government did provide assistance to Western provinces during that era.

Provincial-Canada bond spreads – the yield differential between them – are more stable than corporate-Canada spreads, reflecting the fact that a province is less likely to experience an event that affects its credit than a corporation.

But spreads do change over time. In the 1990s, spreads were relatively wide, due to perceived risks about provincial debt levels. The yields on 10-year Quebec issues averaged about 70 basis points higher than the equivalent federal bond. Ontario issues averaged about 45 basis points over Canada’s. From 2000 to just before the 2008 financial crisis, Ontario and Quebec 10-year spreads averaged roughly 35 and 45 basis points, respectively.

From about 2010 to the outbreak of COVID-19, spreads between Ontario and Quebec issues widened to an average of about 90 basis points. (A basis point is 1/100th of a percentage point.) The increase of Ontario spreads relative to Quebec (and other provinces and the federal government) is because of the relative decline of Ontario’s industrial base and a lack of fiscal conservatism since the 1980s that has caused its finances to deteriorate.

The current 10-year spreads between Ontario and Quebec are around 70 basis points. Provincial spreads against federal bonds are narrower now than they were from 2010 to 2017 and at the levels of the relatively stable 1990s. I would not fret too much over the reasons why this is so. Perhaps it is because federal debt is rising at a high rate, or it could be because market participants are searching for higher yields and buying provincial bonds.

Small spread changes matter less over longer time periods, and an instantaneous 10-basis-point move only changes a bond price on a 10-year bond by about 0.7 per cent, which is hardly worth worrying about. Also, changes in a province’s net-debt-to-GDP ratio seemed to have a barely perceptible effect on spreads, based on history. Provincial bonds have a consistent and stable yield advantage over Canada’s.

Institutional bond managers may have to agonize about provincial spreads since they are under pressure to outperform their competitors by seemingly incremental amounts. Individual investors can just wait and collect larger coupon payments.

Investors can purchase individual provincial bonds. Unlike buying corporate issues individually, credit risk is less of a concern as one is not buying a company that could get into difficulty.

Investors can also increase their exposure by using ETFs. BMO provides ETFs that attempt to replicate the short, mid and long provincial indexes, such as the BMO Long Provincial Bond Index ETF (ZPL-T), BMO Mid Provincial Bond Index ETF (ZMP-T) and BMO Short Provincial Bond Index ETF (ZPS-T).

The iShares Core Canadian Government Bond Index ETF (XGB-T) has 35 per cent Government of Canada issues, and 12 per cent Canada Housing Trust, which holds federally-backed mortgage bonds. The other eight names in the 10 biggest holdings are provincials, which along with Quebec Hydro make up about 44 per cent. The remaining 9 per cent is a variety of government-type issuers. The portfolio has over 430 issues and does not break up individual issuer weights after the first 10.

There are other ETFs providing exposure to provincial issues that investors should entertain. The yield advantage provided by provincials may not seem significant, but they can add up over time by surprising dollar amounts.

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