Municipal bonds are among the least known government issues in Canada, yet, paradoxically, they are among the best yielding and most secure issues on the market.
Some come with strong AAA ratings, which are just about non-existent in the corporate market; all offer yield boosts over the bonds of their home provinces; and none — as far as bond raters and investment bankers can remember — have defaulted since the 1930s.
“Munis” are obscure in spite of their merits. They represent about 2% of the SC universe bond total return index, the leading bond index in Canada, says Stephen Ogilvie, who heads Standard & Poor’s Corp. ’s municipal bond finance desk in Toronto. The issues tend to be bought by institutions, but underwriters often reserve allotments for retail clients.
Munis are rare for the same reason that they are attractive, says Ogilvie: “The explanation for why there is not as much depth in the Canadian municipal bond market as there is in the U.S. is that Canadian municipalities are averse to debt. Their global peers, including those in the U.S., borrow much more.”
As well, he notes, in contrast to the U.S. bond market, in which municipal bonds are immune to certain income taxes, Canadian munis’ interest is taxed as straight income, just like for any other bond. And there is no special tax regime to create a special, tax-free market for munis in Canada.
Buyers of municipals are the usual suspects — pension funds and life insurance companies. They usually hold them to maturity because most of the issues are small, thinly traded and have premiums for their lack of liquidity. The liquidity premium tends to be built into each issue as a small boost on yield of one or two basis points, says an investment banker who handles these bonds. The market may discount the bonds a little more, adding two to six more bps of yield to the built-in premium. But try to sell most of the issues, and the yield premium you received as a buyer will be lost to the next buyer, who will want his or her own “illiquidity discount.”
Therefore, Canadian munis are keepers. They also offer good rewards. For example, the Municipal Finance Authority of British Columbia, which handles debt offerings for towns and cities in the province, recently issued a 10-year bond due Oct. 31, 2016, with a 4.338% yield to maturity. That works out to 31.5 bps of yield over a Canada bond due June 2015, and three bps over an Ontario bond due in March 2016. The issue size was $715 million in total, including a previous issue of the same debt. Rated by Moody’s Investors Service Inc. as AAA (as AA+ by Standard & Poor’s), the issue is an example of the yield and quality offered by the municipal bond market, in which very few issues below investment grade ever get offered.
And, in contrast to the corporate bond market, in which AAA ratings on straight corporate credits are seldom, if ever, issued, several Canadian municipalities — including Saskatoon and London, Mississauga and the regional municipalities of Durham, Peel and Halton in Ontario — offer several AAA credits. Toronto’s credit is rated AA by Dominion Bond Rating Service Ltd. , which also rates Winnipeg at AA (low), Calgary and Edmonton at AA (high), and Montreal at A (high).
Raters quibble about exact ratings, but all munis that get rated are investment-grade, notes Paul Judson, DBRS’s vice president specializing in Canadian munis.
And munis have portfolio values quite different from those of federal and provincial bonds, although all three types tend to be financed by tax revenue that reflects the strength of their respective economies, says Judson: “The credit quality of municipal bonds rests on the taxing powers of the issuers. They have access to property taxes, which are more stable than income tax flows. Property taxes are less sensitive to economic cycles than income taxes relied on by more senior levels of government.”
What’s more, municipalities can seize property if owners do not pay their property taxes, Judson adds. Municipalities can also raise taxes with greater ease than more senior levels of government. Add the rising strength of western provincial economies and the security of munis grows, he says.
@page_break@Nevertheless, munis remain a niche form of finance, partly because of their limited role in Canada. Canadian municipalities tend to be forbidden to operate with deficits, so munis are issued only for capital spending. They tend not to include highway- and road-building projects that are financed with provincial debt. What is left is high-quality debt of political entities barred by law from borrowing for operating costs, financed by means other than reliance on macroeconomic variables.
Munis come in several forms. The basic “bullet” bond, with one due date, is the simplest to analyse. For example, a City of Toronto $100-million issue due Sept. 27, 2016, priced at issue to yield 4.5%, was 43.3 bps over a Canada bond of similar term. There are also “amortizing” bonds that may be issued in series of 10 bonds with sequential due dates. Amortizing bonds can chop up an offering of $100 million — a respectable sum in the munis market — into a series of 10 $10- million bonds, each due one year apart and each subissue too small to support much of an aftermarket.
“Higher yield is the reward for accepting lesser liquidity,” says Dave Burner, senior vice president, government finance, at National Bank Financial Ltd. in Toronto.
“Municipal bonds are appropriate for a buy-and-hold strategy for a time-specific return,” Judson says. “The question is whether the illiquidity is adequately covered by the yield boost.”
“If you use a buy-and-hold strategy for high-quality munis, picking up the yield that can be as much as 10% over the federal bond’s yield, how can you go wrong?” asks Derek Moran, president of Kelowna, B.C.-based consultancy Smarter Financial Planning Ltd. “If you want yield, munis are worth a look, especially if you buy at issue and hold to redemption. That’s no way to get a capital gain, but it’s a great way to earn secure income.” IE
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