Portfolio positioning for provincial bonds

In the midst of economic challenges created by the pandemic, provincial bonds have shown strong performance this year, and will likely continue to do so given central bank support.

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“Despite the challenges, [provincial bonds] retraced about 80% of their widening year to date,” said Adam Ditkofsky, vice-president and portfolio manager at CIBC Asset Management, in a Sept. 2 interview.

At that time, midterm spreads for provincial bonds sat at about 65 basis points, where they remain at the end of September.

“Given this spread tightening and the longer-dated nature of provincial bonds — as most provinces tend to focus their issue in the longer-dated bonds so they can lock in long-term funding — provincial bonds have performed fairly nicely,” Ditkofsky said.

Midterm provincial bonds have returned 9.56% so far this year. according to FTSE Russell.

The strong result is largely attributable to the central bank’s $50-billion provincial bond-buying program. After the program was announced in April, provincial spreads quickly tightened, with midterm spreads tightening by 35 basis points in one week.

“This represented almost 75% of their entire recovery this year,” said Ditkofsky, who co-manages the CIBC Canadian Bond Fund.

That support will remain key, as the provinces face significant economic challenges. Increased spending combined with revenue declines because of the pandemic have the provinces facing increased deficits for fiscal 2020-21.

Collectively, provincial deficits are expected to reach $100 billion, compared to $12 billion last year, Ditkofsky said, and most provinces have removed targets to return to balanced budgets.

“Essentially, all the provinces have seen weakening fundamentals, are running large deficits and have significant borrowing needs,” he said.

Particulars by province

The provinces’ total financing needs have increased to about $150 billion for the current year, or an average of $2.8 billion in new provincial debt per week, Ditkofsky said.

Fortunately, Ontario, Quebec and Alberta have well-established international borrowing programs, which made up 25% to 35% of their total annual debt issues over the past five years, he said.

Further, “The Bank of Canada still maintains more than $40 billion in capacity under its purchasing program,” he said, and would likely step in and increase that capacity if needed.

He also noted that Ontario and Quebec tend to have the most liquidity in the market given the scale of their bond programs.

As of Aug. 31, Ontario, Quebec and Alberta made up the largest proportion of the central bank’s portfolio associated with its provincial bond-purchasing program, at about 42%, 22% and 13%, respectively.

While provinces with more commodity exposure, such as Alberta and Newfoundland, have more risk to their financial budgets, “given the expected federal support, spreads have remained fairly stable in recent months,” Ditkofsky said.

Newfoundland’s economic fundamentals are weakest relative to the other provinces, with a deficit-to-GDP ratio of 7% and net debt–to-GDP in excess of 50%, Ditkofsky said. The province is also at risk of a rating downgrade.

“We don’t see risk of a default, as the federal government would likely step in,” he said. “You’re also being compensated for the risk, with relative spreads versus Ontario in the long end being more than 65 basis points.”

Positioning in provincials

Ditkofsky’s position in provincial bonds is focused on longer-dated issues, with his largest exposures being Ontario and Quebec given their liquidity.

He has overweight positions in Saskatchewan and Alberta, despite those provinces’ commodity exposure.

Those two provinces maintain solid balance sheets with low net debt–to-GDP — less than 20% for each.

“This is compared to other provinces such as Ontario, which is about 40%,” Ditkofsky said.

While Ditkofsky expects provincial bonds to outperform Government of Canada bonds over the next 12 months given their excess spread and carry, he’s underweight provincials overall in an effort to increase his overweight exposure to corporate bonds.

“We maintain the view that corporate bonds will be the winner over the [12-month] horizon,” he said.

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