Fidelity Joins Pimco in Cutting Provincial Bonds: Canada Credit

Provincial bonds are emerging as Canada’s biggest casualties of speculation the Federal Reserve will begin slowing four years of monetary stimulus.

The nation’s provincial debt has proved most sensitive to the prospect of higher interest rates triggered by the withdrawal of bond purchases by the U.S. central bank, losing 4.6 percent this year, compared with 1.3 percent for corporate counterparts. The losses are the first since 1999 and the worst ever, according to Bank of America Merrill Lynch index data.

Brian Miron, manager of Fidelity Investments’ C$7.9 billion ($7.7 billion) Canadian Bond Fund, has cut the amount of provincial debt he holds to 24.8 percent from 25.7 percent two months ago, according to the latest filings. Pacific Investment Management Co. dropped the allocation of provincial debt in its Canadian Total Return Bond Fund to 40 percent in August, from 43 percent in May, its website shows.

“In an environment where rates are going to rise, you’d rather be in the front end of the curve,” Andrew Kelvin, senior fixed-income strategist in Toronto at TD Securities, a Toronto-Dominion Bank unit, said by phone. “This is collateral damage as part of the broader government bond move insofar as provincials trade in the longer part of the curve.”

Longest Duration

Borrowers led by Ontario and Quebec, the nation’s two most populous provinces, pushed average debt duration, a measure of the securities’ price sensitivity to yield changes, to a record this year to finance budget deficits when rates were low. The two biggest issuers of Canada’s 10 provinces have raised C$23 billion of C$48 billion of planned issuance in the fiscal year ending April 1, according to data compiled by Bloomberg.

“Provincials have underperformed more because the duration of the provincial component of the index is so much longer” than other fixed-income assets, Miron said Sept. 12 in New York at a Bloomberg Link conference. “That certainly is something we take into account when we’re constructing the portfolio in terms of where we want to allocate.”

The longer the duration, the more holders demand as compensation for falling prices and rising yields.

The Fed will decide whether to start tapering $85 billion in monthly bond purchases at a two-day meeting starting today. U.S. central bankers will probably decide to slow purchases to $80 billion, according to a Bloomberg News survey of economists.

Foreign Purchases

Elsewhere in credit markets, Toronto issued C$300 million of 10-year notes yielding 3.935 percent.

Foreign investors bought a net C$3.64 billion of bonds after a record divestment in June of C$19.1 billion, government figures showed yesterday.

The extra yield investors demand to own the debt of investment-grade corporations rather than government debt widened by one basis point to 125 basis points, from 124 at the end of last week, according to the Bank of America Merrill Lynch Canada Corporate Index. Yields held steady at 3.41 percent yesterday.

Federal debt has lost 3.4 percent this year. Canada’s benchmark 10-year government bonds rose, pushing yields down one basis point, or 0.01 percentage point, to 2.77 percent. The price of the 1.5 percent securities maturing in June 2023 rose 8 cents to C$89.29 at 1:08 p.m. in Toronto.

‘Current Situation’

The average duration of provincial debt has dropped since hitting a peak of nine years in April, Bank of America Merrill Lynch data shows. It is now 8.3 years, compared with an average seven years in the Canada Broad Market Index. Both Ontario and Quebec have weighted-average debt maturities of 12 years.

“The current situation where we may in the future see investors want a bit more shorter-term than longer term is not a problem really with us,” Bernard Turgeon, associate deputy minister at the Quebec Ministry of Finance, said Sept. 12 at the Bloomberg Link conference. “Over the past few years we have been able to lengthen the average maturity of our debt. So we are comfortable if interest rates go up because it’s not a large part of the debt that comes to maturity every year. The current situation is not a source of preoccupation.”

The debt of Canadian provinces and local governments remains the largest holding in Pimco’s Canadian Total Return Bond Fund, overshadowing the 38 percent allocation to government debt and 7 percent weighting in corporate credit.

Yield Premium

“I do not expect tapering to disproportionately affect provincial bonds,” Ed Devlin, the London-based manager of the fund, said in an e-mailed response to questions yesterday.

Roland Lescure, chief investment officer at Caisse de Depot et Placement du Quebec said his firm still favors provincial securities because they are safe investments that offer extra yield. He was also speaking in New York on Sept. 12 at the Bloomberg Link conference.

Provincial bonds yield an average 73 basis points more than federal debt, according to Merrill Lynch data. The debt of Ontario, Canada’s largest provincial borrower, is rated Aa2 by Moody’s Investors Service and AA- by Standard & Poor’s, third and fourth highest of 10 possible investment grades. Quebec is rated Aa2 by Moody’s and a grade lower by S&P at A+.