A rating action on Canada’s economic powerhouse, Ontario, could be more relevant for bond investors than a downgrade of the federal government as the province risks an unsustainable rise in debt, according to US$2.3 trillion asset manager Capital Group.

The investment firm’s Thomas Reithinger sees Ontario among provinces with a higher downgrade risk, which could eventually trigger discussions about a redistribution of the country’s tax revenues. Canada’s latest budget projects a slow decline in the ratio of debt to gross domestic product at the federal level.

But the subnational government sector -- mainly provinces -- has settled into a soaring trajectory, according to a November report from the federal budget watchdog that said most provinces are on an unsustainable fiscal path.

“Over the long term, the federal government gets lower and lower debt levels and the provinces get higher and higher,” said Reithinger, a fixed-income portfolio manager. “At some point there will be a negotiation between all provinces and the federal government to recalibrate that in order to bring the provinces back down to more manageable levels.”

A permanent tax increase or spending cuts of about 0.5 per cent of gross domestic product would be needed to stabilize the subnational government net debt ratio at its pre-pandemic level of 24.1 per cent of GDP over the long term, the Parliamentary Budget Officer said in the report. That reduction would amount to $12 billion (US$9.9 billion) in current dollars, growing in line with GDP thereafter.

“I would say the risks of downgrades are much more prominent on the provinces, maybe on the federal government too but I don’t think it matters to the market,” said Reithinger, adding that they are “concentrated more in provinces that we think are our higher quality and have better trajectory,” such as Saskatchewan, Quebec and British Columbia.

Record debt

Ontario, the world’s largest sub-sovereign bond issuer, is projecting its net debt-to-GDP to reach 50.2 per cent by fiscal 2023-2024, up from a record high 47.1 per cent at the end of the last fiscal year, according to the budget documents released in late March.

The province’s “debt burden will rise to levels seldom recorded for regional governments around the world,” Michael Yake, a senior vice president at Moody’s Investors Service, said in an emailed statement after Ontario’s budget was released. The ratings company assigns Ontario Aa3, its fourth-highest investment grade, while giving Canada’s federal government its top designation.

Ontario has a long-term borrowing plan for the current fiscal year of $53.9 billion, of which $9.8 billion has already been raised, according to government data.

Health costs

“It’s the longer term that we’re more concerned about” because education and health-care programs, which consume roughly half of the provincial budget, are only going to get more expensive, said Ontario’s Financial Accountability Officer Peter Weltman, whose department is scheduled to release a report about the province’s debt sustainability in June. That’s especially true of health care, due to the aging of the population, he said.

The pandemic has prompted an “unprecedented amount of fiscal cooperation between the federal government and provinces,” Weltman said in an interview. But “it’s also exposed to a lot of structural problems” so there may be more of an appetite for a discussion about spending and tax authority than there was a decade ago, he said.

To be sure, potential talks about transfers between provinces and the federal government have surfaced before. Most recently Alberta has been lobbying Ottawa as the western province has faced a decline of its oil-related revenues in recent years.

Regarding such talks, “I don’t think that’s going to happen in at least over the next year or over the next budget cycle,” said Reithinger. “That is going to require either some sort of market forcing them to do it or the rating agencies or the province saying hey, we’re getting downgraded here.”

Until then, provinces have easy access to cash. Borrowing costs remain at historically low levels in part because the Bank of Canada stands ready to buy some their bonds if macroeconomic conditions dictate as happened at the start of the COVID-19 crisis.