Investors worldwide waited by their screens for the results of the Quebec referendum on separation from Canada. With holdings in Canadian government and corporate debt surpassing the C$350 bn mark, billions of dollars in potential losses hung in the balance. For debt portfolio managers worldwide, it was as long a night as it was for the people of Canada. The final result (50.6 per cent voting to stay in Canada) came unusually late in the evening, but the numbers were just conclusive enough to stop an all-out sell-off. For now.
‘The referendum was like pressing on the brakes and stopping one inch from the brick wall,’ says Ihor Kots, managing director of Montreal-based Canadian Bond Rating Service (CBRS), one of the country’s top two rating agencies. ‘A massive sell-off could have occurred had the pro-separation vote won. After all, the world debt market does not want to deal with a headache in a market that may make up a few per cent of the world bond index.’
These few per cent do add up. According to CBRS, Canada’s federal debt is over C$600 bn; and total public sector debt is 126 per cent of GDP (C$787.8 bn), or C$992 bn outstanding. Add in corporate debt and the total nears C$1.5 trillion. With numbers like that, Canadian debt ratios rival those of Italy and Belgium, and come dangerously close to some developing countries.
The federal government is by far the biggest debt issuer, with C$129 bn of its debt payable abroad. But the provinces of Ontario and Quebec have been the most prolific global issuers over the years. Creative finance departments have brought impressive billion dollar-plus globals and jumbo Yankee issues to the market. Often seen as a pioneer in global debt markets, Province of Quebec and utility Hydro Quebec have led the way in Japanese and Euro markets over the last two decades; and both have issued Yankees for over 40 years.
‘We need no introduction to Wall Street,’ says David Blustein, manager of capital markets at Hydro Quebec. Blustein jetted to New York to take the market pulse with Hydro’s treasury team, including two IR professionals, as soon as the referendum dust settled. ‘The US market is too big, and Hydro too big an issuer, for IR to make much of a difference in issuance price,’ he says. ‘But we have a direct effect on investment decisions, and have seen a direct relationship between visits to investors and subsequent purchases of debt.’
The Province of Quebec’s public sector debt totals C$145.7 bn, and Ontario has been playing a game of catch-up with Quebec. A ballooning deficit pushed the treasury into international markets for almost C$1 bn a month in 1994, only slightly less in 1995. To ease the IR function and make a better case in global markets, Ontario and Ontario Hydro have merged their issuance programmes, producing handsome pay-offs in investor demand.
But Canada’s well-versed global IR teams could do little to make investors less skittish in the days before the vote. When opinion polls showed a narrow lead for the separatists, a rapid sell-off sent the yield spread of Canadian 10-year bonds over the US government 10-year benchmark to a yearly-high of 200 basis points, up from 130 bps in May. It seemed as if foreign investors were caught off-guard by separatist sentiment.
Analysts were forecasting that the spread would be as high as 275 bps if the vote went in favour of separation; as low as 110 bps if it went against. ‘It was difficult during the referendum, but even since the vote we have never seen such a confusing market,’ says Peter O’Marra, a veteran bond dealer for Toronto-based Richardson Greenshields. ‘The market lurches from overbought to oversold. There is little doubt investors are worried about Canada risk, and some are wondering if it is still worth it.’
‘Most of the world used to think Canada was so stable it was boring,’ adds Kots. ‘With the referendum, the world realised that Quebec, and all of Canada, has debt problems. The photo finish made investors very nervous. Still, the depth of issuer information has improved, and the spirit of open communications is important to the market,’ he says.
In terms of Quebec, investors were concerned that separation would exacerbate an already heavy debt load. Toronto-based CD Howe Institute predicts a ‘best case scenario’ that shows a separate Quebec with a debt-to-GDP ratio of 106 per cent, and a budget deficit of 9 per cent of GDP. There are worse figures, but mostly only in developing countries. Quebec accounts for some 23 per cent of Canadian debt, on a per capita basis; and investors are quaking over Quebec statements about assuming a fair share.
On referendum day, the spread between US and Canadian 10-year bonds narrowed to 150 bps. But by late December, the long end of the market stood around the 200 bps level. In other words, the worry remains. Moody’s, which blasted Canada in April with a downgrade of its dollar debt to AA1 from AAA, warned of ‘negative rating implications’ in the wake of the referendum. Moody’s believes the vote means constitutional issues will muscle further into the government’s agenda, diverting attention from the deficit.
In June, citing a lack of budgetary progress and an escalating debt burden, the agency dropped its Quebec rating from A1 to A2, which it affirmed after the referendum. ‘For the medium term, there is still a question as to how the government will remain focused on its budgetary challenges while furthering its political agenda,’ says Yves Lemay, Moody’s vice president and head of Canadian ratings in New York. ‘Constitutional issues will likely remain a source of distraction in Quebec and lingering political uncertainties may continue to hinder economic conditions.’
Ontario wasted no time getting its house in order after the referendum. In November it took steps to trim its C$9.3 bn deficit – already reduced from a high of some C$14 bn – with spending cuts labelled ‘absolutely brutal’ by critics. The rating agencies affirmed Ontario’s AA3 designation, and applauded its ambitious plan to balance the budget by the year 2001. Lemay says Moody’s decision to maintain Ontario’s rating came after extensive discussions about medium-term strategy with the new provincial government.
Marketing debt has not been a problem for Ontario. ‘With the strength of the Canadian economy and a dearth of provincial issues, there was tremendous domestic appetite for debt in 1995,’ says John Mulligan, treasurer of Ontario Hydro.
Mulligan launched four domestic issues worth C$2 bn in 1995, at the narrowest spreads over Canadian government bonds in years. ‘Even during the referendum run-up, the market was favourable. It has been steaming along ever since. There has been such a feeding frenzy at home that we didn’t even have to go to the global markets.’
Just a few years ago, when Ontario Hydro was putting finishing touches to its last nuclear plant, annual debt issuance was of the order of C$6 bn. The debt-equity ratio was 92 per cent and investors were clamouring for change. Now Mulligan is on an aggressive programme to reduce the ratio to below 70 per cent by 2002. Over the next five years, the utility will only be borrowing C$1-2 bn a year, and Mulligan hopes for an improved credit rating (currently AA3) to reflect the progress of both Hydro and the province.
Overall, investors and rating agencies are encouraged by the 1995 budgets, with provincial deficits totalling C$13.3 bn, against C$25.6 bn three years ago. Bankers expect the provinces to adjust their strategies to the harder borrowing environment, but note that with fewer issues near-term, refinancing needs will grow in the late 1990s. Projections peg provincials’ borrowings at C$15-20 bn annually, compared with the current C$10-15 bn.
For IROs caught in the maelstrom of communicating Canadian debt, Kots does not understate the challenge. ‘It’s hard to convey to investors a rosy picture of a country with high deficits and underperforming fundamentals,’ he says. ‘But things are looking up, with governments getting their act together. If anything, all the attention garnered by the referendum has helped educate investors about the country, and made the IR task a little easier.’
Separation and Power
Few among Canada’s debt issuers is faced with a greater challenge than the treasury department at Hydro Quebec. With pressure on Quebec ratings and global investors worried about the impact of separation on the province’s debt, David Blustein, assistant to the treasurer of Hydro, must help make a strong case to keep investors interested in the company’s issues.
Along with investor relations swat teams from the federal government, Province of Quebec, Ontario, and a flock of provincial issuers, Blustein spends much of his time on roadshows explaining the virtues of Hydro debt. His job has been made easier by a savvy finance crew: Hydro averaged C$4.3 bn in debt issuance a year during 1990-94 and an estimated C$2.2 bn in 1995 and 1996. With some foresight, the utility completed its financial programme for 1995 by early summer to avoid being affected by referendum volatility.’It’s was just not convenient to issue debt during a major political debate,’ says Blustein. ‘As for dealing with separation questions, as a company we cannot talk about how the province is organising for political change.’
However, he does answer questions on how politics affects operations, the company’s position in the political debate, and on the impact of market volatility.
‘Regardless of the political situation in Quebec, people will still have to turn on their lights,’ adds Blustein. ‘As a low-cost producer of a key energy resource, we don’t look at the political future with trepidation. Our basic message is that Hydro is decreasing its investment and borrowing programme, and that this will have a direct affect on the value of our debt.’
Hydro’s IR team – two professionals, two support staff – has been in place for six years. They maintain a steady stream of information about company strategy to investors, analysts and brokers, sending out an annual report, a financial profile, four-page briefs on investor-related topics, and a one-page profile for bond desk salespeople.
Along with the province, Hydro was downgraded by Moody’s from A2 to A1 in June. Blustein discusses ratings with investors and agencies, and uses other utilities as a comparison. In terms of sales, Hydro ranks fourth among industrial utilities, and its debt-equity ratio belies its rating.
‘There is still much to be done,’ concludes Blustein. ‘Our 30-year issues in the US are coming in at around 100 bps over US Treasuries. We believe this is too high considering the value of our credit and we do not feel that we should be paying such a risk premium. That has got to be addressed in the future.’
