Provincial debt unique in global market

(May 2006) While there is little tolerance for deficit spending among Canadian taxpayers, the fact that our provinces are able to do this in the first place has, ironically, saved taxpayers billions in lower interest charges.

“Canadian provinces have more autonomy than almost any other sub-national governments anywhere else in the world,” said David Rubinoff, vice-president and senior credit officer at Moody’s, speaking at a recent luncheon held by the Toronto CFA Society. “They’re much more like sovereigns than they are like sub-sovereigns.”

Provincial bonds are unique in the world of sub-sovereign debt. Most of Europe is dominated by strong centralized governments. Even in the U.S., where individual states are theoretically autonomous, many have passed legislation prohibiting deficit budgets. The fiscal flexibility of Canadian provinces that allows them to run deficits or raise their tax rates, makes their debt more akin to national issues.

“Ontario has so much flexibility, it’s more like a sovereign government,” he said. “In a lot of these countries in Europe, it’s the national government sets the policies — the regional governments have very little authority to change tax bases or change tax rates.”

That flexibility allows provincial governments to issue more debt than most of their international counterparts and still maintain superior credit ratings. Of course, that flexibility can also lead them into trouble, as many provinces learned in the 1980s and 1990s.

Most seem to have learned their lesson and now look further ahead than before, using contingency reserves and rolling over fiscal stabilization funds. Provinces which have successfully eliminated their deficits have shifted their focus from the income statement to the overall balance sheet and are tackling the debt accumulated in the past.

“The new fiscal discipline that we’ve seen put in place in the late 1990s has been sustained over the past decade,” he said. “The provinces are now very mindful of their budget constraints.”

For the most part, Rubinoff does not expect a return to the free-spending budgets of the past.

Provincial debt makes up about 25% of the $600 billion Canadian bond universe, according to Andrew Hainsworth, a director in BMO Nesbitt Burns’s government group. It is becoming an increasingly large portion, thanks to reduced federal issuance — Canada’s sovereign bonds have declined from 62.8% of the domestic universe to just 44.5%.

Ontario is by far the largest provincial debt issuer, borrowing about $20 billion per year — about equal to all other provinces combined. The province is expected to balance its budget in 2008 and 2009, but will continue its usual issuance to maintain liquidity. Refinancing maturing debt is the single largest expenditure in the province, totalling $15 billion a year.

Most provinces prefer long-term, fixed rate issues, with 10 years proving the most popular term. Due to their low yields, retail investors have traditionally not made up a large part of the market.

Moody’s is considering adopting a new way of assessing credit risk, which could further improve provincial debt ratings if put in place. Joint Default Analysis assesses the likelihood of not only the regional government defaulting on its debt, but whether the national government would step in to avert that default.

Such analysis would take into consideration the historical precedent (there is none in Canada), the institutional framework of managing conflict, and the financial implications such a default would have across the rest of the country.

“Looking at historical precedent, in Canada there’s not a lot we can learn,” says Rubinoff. “Provinces have certainly been in trouble and received extra transfers, but it’s not really been to avoid a default.”

Perhaps the strongest point in Canada’s favour is the assessment of reputation risk. The international loss of face associated with, say, a credit default by Ontario, would virtually force the federal government to bail the province out. Provinces which might escape international attention, such as Prince Edward Island, would be probably involve such a small amount of money that Ottawa would not think twice about writing the cheque.

Chief among the risks the provinces face is the rising cost of healthcare, which is growing faster than revenues. This has forced the various governments to refocus on priority areas of the government, spending less on peripheral programs.

“We don’t expect to see any magic bullets solve the healthcare issue,” Rubinoff said. “We expect to see continued evolution of the system, with some provinces pushing the limits.”

Quebec and Newfoundland also face underfunded pension obligations, but he said his firm does not consider these to be debt when making their analysis.

Another challenge seen in the future is increased foreign competition for Canadian investors’ fixed income portfolio.

When the foreign property rule was dropped, foreign issuers seized the opportunity to raise funds in Canada by launching “maple” bonds, which are denominated in Canadian dollars and aimed at our market.

In terms of competition for the investor’s fixed income dollar, Hainsworth said these have had little impact on the larger provincial issuers, whose debt instruments are far more liquid and are so far much larger than any “maple” issue. This could change, however, as the maple market matures and if larger supranational and sovereign maples are brought to market.

While the superior credit ratings on provincial bonds may leave them with lower yields than corporate debt, the risk associated with the provincial issues may make them the right fit for risk averse investors seeking to tweak the returns of their fixed income portfolios. They can either raise the yield of a portfolio laden with Government of Canada debt, or mitigate the risk level for one that is overweighted in corporates.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(05/12/06)