Canadas provinces have not slowed down. Having issued a record C$77bn ($74.7bn) of bonds and medium term notes in the fiscal year to the end of March 2010, they are projected to borrower at least C$73bn in 2010/11, according to figures released by CIBC on September 14, still far above historical averages. And they could print even more than that if they decide to pre-fund. "When the dust settles, fiscal 2010/11 should establish a new record for provincial issuance, with hefty pre-funding driving total supply to nearly C$80bn," says Warren Lovely, senior economist at CIBC in Toronto.
Last years recession forced the provinces to set up large stimulus programmes. As a result, their combined budget deficits were C$30bn in 2009/10. This year they are forecast to be much the same. Ontario, Canadas most populous and richest province, has the biggest deficit, at C$19bn. It is projected to issue about C$40bn of bonds this fiscal year, more than the rest of the provinces combined. Québec, the second most prolific issuer, has a C$12.9bn borrowing programme thanks to its C$4.5bn deficit.
Analysts are far from nonchalant about the state of the provinces finances. But they point out that the deficits are not that large in most cases, averaging 2%-3% of gross domestic product for this fiscal year. "The provinces borrowing needs are significant," says Travis Shaw from rating agency DBRSs public finance team in Toronto. "Some have their largest borrowing programmes on record. But their economies are growing and investor appetite remains strong. We certainly view the deficits and borrowing needs as manageable."
Most of the provinces aim to balance their budgets between 2013 and 2015. Ontario will take longer, however, given the size of its deficit. It plans to return to balance in 2017/18.
Despite their unprecedented supply in the past two years, the provinces have had little trouble tapping bond markets. Locally, demand has been strong, enabling them to sell C$31bn of Canadian dollar deals between January and the first week of September this year, according to Bank of Montreal.
They have also been able to move further along the funding curve, increasing the average term of their local bonds from 11.3 years in 2009 to 17.6 years in 2010. Deals of five years or less have made up just 14% of issuance this year, far less than the average of 32% between 2000 and 2009.
Anything Canadian is hot
Pricing has remained attractive for issuers. Spreads, after narrowing slowly in the first quarter, widened in response to the eurozone sovereign debt crisis. Ontarios 30 year bonds, for example, moved from about 60bp over the Government of Canada curve to almost 100bp by mid-May. But the market was still open during that time, with Ontario issuing two C$750m 10 year bonds in April and May. And since then, spreads have regained about half of what they lost. "The provinces have been well supported this year," says Grant Williams, head of government finance at Bank of Montreal in Toronto. "Spreads widened in the wake of the eurozone crisis, but bounced back in the late spring. Demand has generally held up well."
The provinces have also been able to exploit growing international demand for Canadian paper. By early September they had sold C$12bn of non-Canadian dollar bonds, equating to 30% of their overall issuance. "Anything thats Canadian has been hot property," says Eric Giroux, head of Canadian debt capital markets at Bank of America Merrill Lynch in Toronto. "The public sector issuers have benefited from strong local and international demand. Weve seen more US dollar issuance this year than weve had for a long time."
The demand from US dollar investors has led to benchmarks from British Columbia, Nova Scotia, Ontario and Québec. British Columbias $1.5bn bond in late April particularly excited bankers and investors, being the triple-A rated borrowers first US dollar deal and benchmark since 2003. BAML, CIBC and RBC Capital Markets led the trade, which was priced at just 32bp over Treasuries and 11bp above mid-swaps.
Québecs $1.5bn 10 year bond in July was its first in US dollars for two years. And Nova Scotia had not been to the US market since 2007 before its $750m five year trade the same month.
Ontario has, once again, easily been Canadas busiest province abroad. It had printed $8.75bn of US dollar deals, through four benchmarks transactions, by early September. Like last year, it aims to do about half of its funding abroad, not wanting to increase its domestic issuance to the point where it saturates the market.
Swap spreads ease
Pricing for US dollar deals has proved alluring for the provinces, which swap such debt back into their local currency. Canadian dollar funding has tended to be cheaper throughout the year, but usually by no more than a few basis points. Québecs $1.5bn note was less than 5bp more expensive than what a local bond would have cost, according to Bernard Turgeon, associate deputy minister at the Québec Ministry of Finance in Québec City. Moreover, raising that amount domestically would probably have had to be spread out over three transactions.
By early September swap spreads had tightened further, making US dollar issuance even more enticing. "Provinces can now print three to 10 year US dollar debt at better rates than their domestic cost of funds," says Doug Bartlett, head of government finance at CIBC in Toronto.
If the arbitrage remains, Canadian provincial issuance in US dollars could total $20bn by the end of the year, reckons CIBCs Lovely.
In contrast, international issuance outside the US has been almost non-existent. Ontario is the only one of the provinces to have tapped other currencies this year, selling a Sfr400m ($396m) 10 year bond in April and a ¥133bn ($1.4bn) five and 10 year note a month later. And it is the only one to have issued in euros printing a Eu1.25bn 10 year deal on September 28 despite the sovereign showing how strong demand for Canadian paper in the currency is when it sold a highly popular Eu2bn 10 year note in January at just 2bp over mid-swaps.
Provincial borrowers have been put off foreign currencies, apart from the US dollar, this year by punitive swap spreads. But euro funding, which has frequently been about 40bp more expensive than Canadian dollar debt, has got more attractive in the last two months, hence Ontarios trade. "The provinces would be very much in favour of issuing in euros if they could get pricing similar to that at home," says Giroux. "Its just a function of arbitrage. But its getting better."
The provinces have hardly suffered from only selling Canadian and US dollar bonds. Such has been the level of demand in those two markets that they had already sold about C$40bn of paper, amounting to 55% of their borrowing programmes, by the first week of September, only five months into their fiscal years. Ontario was on track with it funding, having completed about 46% of its requirements. Québec, which has traditionally kept ahead of its needs, was again the furthest ahead of the bigger provinces, being about two-thirds of the way through its programme by the start of September.
The growing demand for Canadian paper from foreign buyers has mostly been for Government of Canada bonds. But the provinces have also benefited, with investors attracted by the countrys economic growth and fiscal standing relative to other industrialised nations, as well as the strength of its banking system. Those buying the provinces Canadian dollar debt, as opposed to their international bonds, also expect the currency to appreciate. "The surge in foreign investor demand particularly from central banks and sovereign wealth funds has allowed public sector institutions to fund their deficits more easily and more cheaply than would otherwise have been the case," says Lovely.
The provinces fiscal positions have improved faster than expected over the last year. Canadas real gross domestic product grew at an annualised rate of 6.1% in the first quarter, more than any other G7 country, and unemployment fell sharply. Provincial governments have therefore had higher tax revenues than anticipated. Last October, Ontario forecast a budget deficit of C$24.7bn for 2009/10. But by March it had revised this to C$21bn. And in August the number fell again to C$19.3bn, meaning the province had seen a C$5.4bn fiscal swing in the space of just eight months.
But provincial supply is unlikely to let up over the coming six months, despite the better fiscal outlooks. Investors and bankers are already speculating about pre-financing for the 2011/12 programmes, given the benign funding conditions at present. Québec, which is forecast to have C$17bn of funding requirements in 2011/12, is the most likely to do so, with analysts saying that C$4bn of pre-funding is realistic. "Over the past 10 years, we have done some pre-financing in the last few months of every fiscal year to take advantage of the conditions on the markets," says Turgeon. "Well probably do the same thing this year because we can foresee that the borrowing programme is going to be finished much before the end of March 2011."
Most analysts say pre-funding would be prudent given that Canadas GDP has slowed since March, dragged down by a weak US economy. In September, CIBC downgraded its Canadian real GDP growth forecast for 2010 from 3.2% to 3%, and for 2011 from 2.5% to 2.3%. As such, while most provinces should beat growth and revenue targets for 2010, they will not do so by as much as many analysts had hoped earlier in the year.
Pre-funding will be all the more important given that the provinces will probably look to borrow about C$75bn in 2011/12, making it their third year in a row of record or near-record issuance. Coupled with lower revenues, this could trigger rating downgrades and make their funding more expensive. "A steady drumbeat of supply means wider spreads even in the face of todays steady investor demand," says Lovely.
The provinces should overcome these obstacles if they keep to their debt reduction programmes. So far their fiscal discipline, which, along with the strength of the economic recovery, will determine how quickly they return to balance, has satisfied bond investors. But the provinces cannot slip. "At the moment theyve struck the right balance," says Eric Beauchemin, managing director of DBRSs public finance team. "But they have to ensure that returning to balance in a reasonable timeframe remains one of their top priorities. Theres always the temptation to boost spending, especially if growth slows, and say: Well just pay it back later. That happened in the 1980s, with negative consequences."
Investors echo such comments. "Investors are concerned about the provincial deficits," says Hosen Marjaee, senior portfolio manager at MFC Global Investment Management in Toronto. "This is especially true of Ontario. Wed definitely like them to make progress on that front and reduce their funding requirements."