Latest / How Canadian Markets Work / Episode 36: Provincial and Municipal Debt

Transcript

Episode 36: Provincial and Municipal Debt · How Canadian Markets Work

0:00
Imagine a quiet, just a normal Tuesday morning,
0:04
the federal government in Ottawa, they decide
0:07
they need to borrow some money to fund their
0:09
operations. And on that exact same morning, a
0:13
province like, let's say, Ontario decides to
0:15
borrow money too. So they go to the markets on
0:17
the exact same day, they borrow in the exact
0:21
same currency, and they borrow for the exact
0:22
same amount of time. And yet... the province
0:25
pays more for that money. They do. So why? I
0:28
mean, today on our deep dive, we're looking into
0:30
this massive yet strangely kind of overlooked,
0:33
quiet corner of the financial world. And that's
0:36
Canadian provincial and municipal debt. Our mission
0:39
today is to uncover, well, why Canadian provinces
0:43
carry such an astonishing amount of debt. how
0:46
the market actually prices that debt and what
0:48
this quiet machinery means for your own long
0:51
-term investment. Right, because it really does
0:53
affect everyone. Exactly. OK, let's unpack this.
0:55
We have this bizarre reality where two levels
0:58
of government borrow simultaneously, but the
1:00
province is charged a premium. Yeah, and to really
1:04
understand the price they pay. we first have
1:07
to look at the sheer, just the monumental scale
1:10
of what the provinces are actually doing. Right.
1:13
Because Canadian provinces are among the largest
1:15
sub -sovereign borrowers in the entire world.
1:18
Wow. Okay, so just to make sure we're entirely
1:21
clear on the terminology here, when we say sub
1:23
-sovereign, we mean they're a level below the
1:25
federal national government, right? But they're
1:27
still out there, like, borrowing directly on
1:29
the global stage. That is correct, yeah. They,
1:32
um... They don't have the power to print a national
1:36
currency, which is what makes them sub sovereign
1:38
But to put the scale gently into perspective
1:41
here Some individual Canadian provinces issue
1:45
more debt on the global markets than actual sovereign
1:47
national governments do that is, wow, which if
1:51
you're just glancing at the headlines, that might
1:54
sound a bit alarming, right? It might sound like
1:57
someone has just completely lost control of the
1:59
provincial checkbook and is just spending recklessly.
2:02
Yeah, the immediate instinct is often to assume
2:05
mismanagement. You know, the sources are incredibly
2:09
clear on this detail. It is not a symptom of
2:12
mismanagement. OK. It's it's entirely structural.
2:15
It's built directly into the constitutional division
2:18
of powers. So back when the responsibilities
2:21
of the country were divided up, the provinces
2:24
were handed the responsibility for health care
2:26
and education. Oh, right. And those are not small
2:29
line items. Not at all. Health care and education
2:31
are well, they're the two. biggest, heaviest,
2:34
most relentless spending areas in essentially
2:37
every developed country on earth. Exactly. And
2:39
they're highly sensitive to things like inflation,
2:42
demographics, an aging population. Yeah. If we
2:45
connect this to the bigger picture. You simply
2:48
cannot meaningfully compare Canada's national
2:51
debt to the national debt of other countries
2:53
without combining the federal debt and the provincial
2:56
debt together. Right. You have to look at the
2:58
whole puzzle. Exactly. If you look only at the
3:01
federal balance sheet, you are looking at a fraction
3:03
of the structural reality. Other national governments
3:07
carry the burden of health care and education
3:09
on their own federal books. But in Canada, that
3:13
massive weight rests heavily on the provinces.
3:16
You know, I picture this kind of like two roommates
3:18
sharing a very large, very old house. Oh, yeah.
3:23
That's a good way to look at it. Right. And they
3:25
signed a lease that legally forces one roommate,
3:28
so the provincial roommate, to pay for the roof
3:30
and the plumbing. And the roof is health care.
3:33
The plumbing is education. Those are, without
3:36
question, the most expensive, unpredictable parts
3:39
of maintaining a house. Well, the federal roommate,
3:41
they pay for the Wi -Fi, the security system,
3:44
maybe the groceries. Yeah. uneven split of the
3:47
heaviest burdens. It really is. But this brings
3:50
us to a rather uncomfortable question about the
3:52
bond market. Okay. Does the global market look
3:54
at that constitutional lease? You know, understand
3:57
the division of powers and give the provincial
4:00
roommate a pass? No. The market does not give
4:04
passes based on constitutional history. Right.
4:07
The market demands compensation for risk no matter
4:10
how understandable the origin of that risk might
4:12
actually be. because the provinces absolutely
4:16
must borrow heavily to keep the roof repaired
4:18
and the plumbing flowing, as you said, they have
4:20
to go to the market constantly. And the way the
4:22
market decides what to charge them is elegantly
4:26
simple in its structure. It all comes down to
4:28
a concept called the spread. The spread, okay.
4:31
Since the federal government is the benchmark,
4:35
sort of the absolute baseline of safety in the
4:37
country, I assume the province is priced relative
4:40
to that federal baseline. Yes. Provincial debt
4:42
is priced as a spread or a gap over the equivalent
4:45
government of Canada bond. OK. So let's let's
4:48
just walk through it methodically. If the federal
4:50
government issues a five year bond and the market
4:53
demands a three percent yield, a province might
4:55
have to pay, say, 3 .6 % for a five -year bond
4:59
on the exact same day. I see. That gentle gap
5:01
of 0 .6%, that is the spread. Right. And in the
5:05
quiet rooms where institutional traders operate,
5:08
they speak in a very specific forehand, don't
5:10
they? They do. Our sources mention, they quote
5:12
this as, Canada plus 60. Canada plus 60. Yeah,
5:15
that means 60 basis points with one single basis
5:18
point being one hundredth of a percent. Right.
5:20
So the baseline Canada level is common to everything.
5:22
The plus 60 is where the actual judgment happens.
5:25
Oh, wow. That spread is the living, breathing
5:29
consensus of the market's opinion of that province
5:32
on that specific day. So if Ontario and Alberta,
5:36
let's say, have totally different economic engines.
5:40
Like, one is rooted in manufacturing and services,
5:42
and the other is deeply tied to natural resources.
5:45
I assume the market prices them differently based
5:47
on their underlying health. Yes. That underlying
5:50
health forms the bedrock of the spread. It's
5:52
the first major driver, which is credit quality.
5:55
Credit quality. OK. The market looks at the province's
5:59
fiscal position. They look at the debt to GDP
6:01
ratio, the diversity of the economic base, and
6:05
the government's willingness to balance a budget
6:07
over time. So a province with a booming, diverse
6:11
economy will naturally command a tighter, smaller
6:14
spread than one facing a severe economic contraction.
6:18
But wait, let's look at a massive province like
6:19
Ontario again. Because they have a huge economy,
6:22
but they also issue a staggering amount of debt.
6:25
Doesn't the sheer size of their borrowing make
6:27
it harder to sell? Like a company trying to offload
6:31
too much inventory at once, I would think the
6:33
market would penalize them for being so large.
6:35
You know, it is highly counterintuitive, but
6:38
the opposite is actually true in the bond market.
6:42
Really? Yeah. And that brings us to the second
6:43
driver, which is liquidity. Because large provinces
6:46
issue such a vast amount of debt, their bonds
6:50
trade easily and constantly. Oh, I see. Institutional
6:53
buyers know they can easily find sellers, and
6:55
sellers know they can quickly find buyers. Because
6:58
an institution never wants to be trapped holding
7:00
an asset they can't sell if they suddenly need
7:02
cash. Exactly. It's exactly the opposite of a
7:05
penalty. That ease of movement is highly valued
7:09
by investors because it's easier to trade. Investors
7:12
actually demand slightly less compensation. Wow.
7:16
So paradoxically, the sheer volume of debt from
7:18
a large province results in narrower, cheaper
7:22
spreads compared to a tiny province whose bonds
7:25
rarely trade. That is so interesting. OK, but
7:28
what if a province? Regardless of its size or
7:31
credit quality, just needs a massive influx of
7:34
cash right now. Like, say they announce a massive
7:36
infrastructure program and suddenly they need
7:38
to borrow billions more than they did last year.
7:40
Then they run into the third driver, which is
7:43
supply. Supply. And supply is simple gravity.
7:45
If a province has an aggressive borrowing program
7:48
slated for the year, they have to attract a larger
7:50
crowd of buyers to absorb all those new bonds.
7:53
Right. And to coax more buyers into the room,
7:55
you have to offer a slightly sweeter deal. OK,
7:58
that makes perfect sense. So the spread widens,
8:01
meaning the province pays more, simply because
8:03
of the sheer volume of supply they are pushing
8:05
into the market over a short period. So even
8:07
if their economy is perfectly healthy, just the
8:10
act of asking for too much money at once drives
8:13
their price up. Yes. Okay, that makes sense.
8:15
But what if the world outside of Canada is falling
8:17
apart? What if there's, you know, a global banking
8:20
crisis or a geopolitical shock? Ah. That introduces
8:24
the fourth driver. Sentiment. Sentiment. Sentiment
8:27
is the macro tide. In periods of broad market
8:30
stress or global anxiety, investors seek the
8:33
absolute safest harbor. They want pure security.
8:36
Right. So they flock to federal bonds. Exactly.
8:39
When that happens, all provincial spreads widen
8:42
together as a group. Wow. The market almost completely
8:45
ignores the individual circumstances or good
8:47
behavior of any specific province. It's the tide
8:50
pulling all the boats out at once. So if I'm
8:53
an investor looking at a screen and the spread
8:55
is just a single number, like let's say it moves
8:57
from Canada plus 60 to Canada plus 80 on a Tuesday
9:00
morning, how do I untangle those threats? How
9:04
do I know if that 20 -point jump is because of,
9:06
you know, credit quality, a sudden surge in supply,
9:09
or just a really bad global mood? The short answer
9:12
is you don't. You don't untangle it, at least
9:16
not with absolute mathematical certainty. The
9:18
spread does not politely decompose itself on
9:21
your screen and tell you that 10 basis points
9:23
were due to supply and 10 were due to sentiment.
9:26
Right, right. It is a continuous blended verdict.
9:29
It's being updated in real time by thousands
9:32
of people with actual heavy amounts of money
9:35
at stake. Which I guess makes it vastly faster
9:38
and more responsive than an official credit rating
9:40
agency might only publish a comprehensive report
9:43
once a year. Yeah. The spread is really the truth
9:46
of the moment. And speaking of the truth of the
9:48
moment, if we look closely at where these spreads
9:49
actually sit, they reveal a very quiet, very
9:53
profound quirk of Canadian fixed income. If the
9:57
global market is constantly evaluating these
9:59
provinces, what happens if that provincial roommate
10:02
gets into serious, undeniable financial trouble?
10:06
Right. Well, if a province were to edge toward
10:08
the brink of a default, what would the federal
10:10
government do? Exactly. The pricing of provincial
10:13
debt in the market includes a partial quiet expectation
10:17
of a federal guarantee. A guarantee. Yes, there
10:20
is an embedded assumption that Ottawa would ultimately
10:23
step in to catch the province before it fell.
10:26
Here's where it gets really interesting because
10:27
our sources are incredibly clear on this. That
10:30
guarantee does not formally or legally exist.
10:33
No, it doesn't. It has never been tested in modern
10:36
times. It is not written down in the Constitution,
10:39
nor is it signed in any binding treaty. What's
10:42
fascinating here is that it is entirely unwritten.
10:45
Yeah. The answer to a true provincial debt crisis
10:49
would be a political answer, not a legal one.
10:52
Right. The federal government has absolutely
10:54
no legal obligation to pay a province's bondholders.
10:58
But the political ramifications of allowing a
11:02
Canadian province to default on the global stage,
11:05
dragging down the reputation of the entire country.
11:07
Well, that would be catastrophic. I think of
11:09
it kind of like a parent who hasn't officially
11:11
legally co -signed their teenager's car loan.
11:14
Oh, yes. Right. Like, the parent Aang's name
11:16
is not on the paperwork anywhere. But the local
11:19
bank manager knows the family, knows they have
11:21
deep pockets, and gives the teenager a much better
11:23
interest rate anyway. The bank is just quietly
11:25
assuming that the parent would never endure the
11:28
social embarrassment of letting their kid's car
11:30
get repossessed. That analogy perfectly captures
11:33
the dynamic. Yeah. And the market's belief in
11:35
this ghost guarantee, this unwritten and parent,
11:38
if you will, is mathematically proven by the
11:42
spread itself. Really? Yeah. We can see the belief
11:44
in the numbers. OK. Walk me through that math.
11:47
How does the spread prove a belief in something
11:50
invisible? Think of the extremes. If the global
11:53
bond markets truly deeply believe that the provinces
11:57
were entirely on their own, just walking a tightrope
11:59
without a net, the spreads would be dramatically
12:03
wider. The gap between federal and provincial
12:06
borrowing costs would be massive, reflecting
12:09
true standalone risk. Right, like if the teenager
12:11
went to a bank in another city where nobody knew
12:14
their parents. Exactly. Conversely, if the markets
12:16
believed that Ottawa explicitly 100 % guaranteed
12:19
every single provincial bond, the spreads would
12:22
be nearly zero. The province would borrow at
12:24
the exact same rate as the federal government.
12:26
Because there would be zero extra risk. But they
12:28
sit comfortably in the middle. They float right
12:30
in the middle. which tells you that an unbelievably
12:33
uncomfortable amount of real institutional money
12:36
is resting gracefully on a purely political assumption.
12:40
It is a very fragile balance of trust. That changes
12:44
the math entirely. Now this makes me wonder about
12:47
the next layer down. If the global market is
12:50
leaning on Ottawa to rescue a province, who rescues
12:53
a city? Does the province offer their own ghost
12:56
guarantee for a tiny town that needs a new water
12:59
treatment plant or, you know, a library? Well,
13:03
cities operate in a much more constrained reality.
13:06
Okay. Constitutionally, they're often described
13:08
as creatures of the provinces. They don't have
13:11
sovereign or even sub -sovereign independence.
13:13
Oh, I see. They exist entirely under provincial
13:15
legislation, and their borrowing powers are strictly
13:19
carefully overseen by the province. So a town
13:21
can't just... issue bonds on a whim whenever
13:25
they want to build a new arena. Not at all, no.
13:27
And even if they were allowed to, an individual
13:30
city or a small town might simply be too small
13:32
to borrow efficiently. Because of the liquidity
13:34
thing we talked about earlier. Exactly. Remember
13:36
our discussion about liquidity? A $20 million
13:40
bond from a small town would be so tiny, so illiquid,
13:44
that the global market would charge an exorbitant
13:47
spread. Just to touch it. Right. OK. Walk me
13:50
through the mechanics of how they solve that.
13:52
If 50 small towns all need 20 million dollars
13:56
for various projects, how do they overcome that
13:59
penalty for being small? Do they just like group
14:02
together? Yes. They use a beautifully cooperative
14:05
mechanism called pooling. Instead of 50 small
14:07
towns going to the global bond market alone and
14:10
paying high spreads, they borrow through provincial
14:13
financing authorities. Okay. These authorities
14:16
aggregate the needs of dozens or even hundreds
14:19
of cities into a single massive highly liquid
14:22
borrower. But if 50 towns are throwing their
14:24
borrowing needs into one bucket, how does that
14:26
work from a risk perspective? Right. Like what
14:28
happens if town number 47 goes completely bankrupt
14:31
and can't pay their share? Do the other 49 towns
14:33
have to cover the bill? Well, that is the brilliance
14:36
of the financing authority model. Before a town
14:39
is even allowed into the pool, they undergo rigorous
14:42
audits by the authority. Oh, OK. And municipalities
14:46
in Canada are generally not allowed to run operating
14:48
deficits by law. So in many of these pooling
14:51
structures, there is a joint and several liability
14:54
mechanism or a dedicated debt reserve fund, meaning
14:57
the entire collective backs the debt. I see.
15:00
Because of this strict provincial oversight,
15:02
the rigorous audits and the pooled strength,
15:05
municipal debt in Canada is generally regarded
15:07
as exceptionally low risk and it secures vastly
15:12
better pricing than any town could achieve alone.
15:14
That makes a lot of sense. Retail investors,
15:18
you know, the people listening to this deep dive,
15:20
they rarely interact with municipal debt directly,
15:22
do they? It seems like a very quiet specialized
15:24
space. It is highly specialized. It is a relatively
15:27
small, highly illiquid corner of the market for
15:29
an individual buyer. Right. When retail investors
15:32
do hold it, it's almost entirely tucked away
15:35
invisibly inside mutual funds or exchange traded
15:38
funds, which actually provides a perfect bridge
15:41
to the listener's own portfolio. Yeah. So what
15:44
does this all mean? Let's bring all these macroeconomic
15:47
mechanics back down to the listener's own savings,
15:50
their own retirement accounts. Why should the
15:53
deeply curious learner care about the spread
15:57
or the ghost guarantee or provincial borrowing?
16:00
Primarily because of hidden exposure. Hidden
16:03
into exposure. Many retail investors thoughtfully
16:05
buy Canadian bond funds and they sleep soundly
16:09
thinking they're buying pure risk -free federal
16:11
government debt. Right, because it just says
16:13
government bond fund on the label. Exactly. But
16:16
if you actually open the hood of those funds
16:18
and read the documentation, these funds very
16:21
often contain massive heavy allocations of provincial
16:24
debt. I assume the fund managers are deliberately
16:27
packing the funds with provincial bonds because
16:29
they want that extra yield. They want the Canada
16:31
plus 60 to make their funds performance look
16:34
better. Exactly. The extra yield you get from
16:36
a provincial bond over a federal bond is very
16:40
real. It boosts the return of the mutual fund.
16:42
But the extra risk is also real. Treating all
16:46
government bonds as one single uniform perfectly
16:50
safe category is a mistake. Wow. You are taking
16:54
on regional economic risk, liquidity risk, and
16:58
the political risk of the ghost guarantee, often
17:00
without even realizing it. So what if a listener
17:02
decides to bypass the mutual fund entirely and
17:05
buy an individual provincial bond themselves?
17:08
Oh, right. Like they see that extra yield and
17:11
want to hold it in their own brokerage account.
17:13
That introduces what the sources highlight as
17:15
the liquidity trap for retail investors. Oh,
17:18
liquidity trap. Yes. Because remember that institutional
17:21
traders deal in blocks of tens or hundreds of
17:24
millions of dollars. Right. If a retail investor
17:26
tries to buy a single small provincial bond,
17:29
say 10 or 20 thousand dollars, The bond dealer
17:33
has to facilitate that tiny odd lot trade. And
17:36
I imagine the dealer does not do that for free.
17:38
They do not. The spread or the hidden fee that
17:41
the dealer charges the retail investor for executing
17:43
such a small transaction can be surprisingly
17:46
wide. It is often so wide. that it completely
17:50
devours the extra yield the investor was trying
17:52
to capture in the first place. So it's not even
17:54
worth it? Usually not. You take on the extra
17:57
risk of holding the provincial bond, but you
17:59
surrender the extra compensation to the dealer
18:01
just to execute the trade. Ouch. Yeah. For small
18:05
amounts, the math rarely works in the retail
18:07
investor's favor. Let's examine that risk closely
18:09
for a second. You mentioned regional economic
18:11
risk. When you buy a provincial bond, You aren't
18:15
just betting on the Canadian economy as a whole.
18:18
Provincial economies in Canada can be highly
18:19
concentrated in specific sectors, right? They
18:22
can. If you buy the debt of a province whose
18:25
revenues are deeply tied to natural resources,
18:28
you are indirectly making a bet on the global
18:30
price of those resources. The province's fiscal
18:33
health, their credit rating, and their spread
18:36
are all dancing to the rhythm of that specific
18:39
commodity, whether it is oil, natural gas, or
18:42
timber. Wait, what about entities like massive
18:45
provincial energy providers or transit authorities?
18:50
Because they aren't provinces themselves, but
18:52
they belong to the government. Do they get to
18:54
borrow under the same umbrella? Ah, you're touching
18:56
on crown corporations. And that introduces a
18:59
fascinating wrinkle. OK. Crown corporations do
19:02
issue their own debt. But the critical distinction
19:05
for an investor is that some of this debt carries
19:08
an explicit legally binding guarantee from the
19:11
parent government and some of it does not. Oh,
19:14
wow. So you can't just assume. No, you cannot
19:17
assume safety based on the name of the corporation
19:20
alone. You must sit quietly and read the prospectus
19:23
to know the difference. Let's take a deep, slow
19:26
breath and pull all these threads together. Good
19:29
idea. We started with the realization of the
19:32
massive structural burden placed on the provinces.
19:35
Because they are constitutionally obligated to
19:37
fund health care and education, they are forced
19:39
to be some of the heaviest sub -sovereign borrowers
19:41
on the planet. Right. And because they borrow
19:44
so much, the market prices their debt using a
19:47
spread over the federal baseline, a spread driven
19:49
by credit quality, liquidity, supply, and macro
19:52
sentiment. And that spread is suspended by the
19:55
ghost guarantee, the unwritten, untested political
19:59
assumption that Ottawa would never let a province
20:02
fail. We looked at how cities navigate their
20:05
own borrowing through provincial pooling to solve
20:08
their liquidity mismatch. And finally, we uncovered
20:11
how all of this hides in plain sight inside the
20:14
average retail bond fund. Which leaves us with
20:17
the lingering question about that ghost guarantee.
20:19
It does. And this brings us to a final thought.
20:22
Something not explicitly spelled out in the core
20:25
of these sources, but a scenario that naturally
20:27
emerges from everything we've discussed. Okay.
20:30
We've established that the global market price
20:31
is in this ghost guarantee from Ottawa, right?
20:34
assuming the federal parent will always rescue
20:36
the provincial child. But what happens if two
20:39
or three massive provinces face a crisis at the
20:43
exact same time? Perhaps due to a synchronized
20:46
global commodity crash, the federal parent might
20:48
have deep pockets, but do they have enough capacity
20:51
to bail out multiple massive provinces simultaneously
20:54
without breaking their own sovereign credit rating?
20:57
That is a very sobering thought. It is a stress
20:59
test the Canadian market has never truly faced.
21:03
And the risk of it is hiding quietly in almost
21:05
every retirement portfolio in the country. Thank
21:09
you all for joining us on this deep dive. Take
21:11
your time. Look closely at what you actually
21:13
own and keep quietly questioning the invisible
21:15
forces shaping your money.