Volatility in the Bond Market: Global Trends, Municipal Risks, and Opportunities

Volatility in the global bond market has dominated financial headlines in recent months. With governments around the world taking on more debt and persistent economic uncertainty, investors are asking for higher yields.

Canada is not immune to this volatility. The Government of Canada 10-year benchmark bond yield reached its highest level (3.99%) in three years on September 29.

Local decision-makers are exposed to the bond market through borrowing costs and investment returns.

Why the Bond Market Impacts Local Governments

On average, municipalities in Canada issue over $14 billion in new or refinanced debenture debt each year.

In Ontario, while existing fixed-rate debt retains its contracted payments, exposure arises mainly through new borrowing, floating rate construction loans, and refinancing. Infrastructure Ontario’s lending rates also reflect its capital market borrowing costs. On the positive side, higher yields increase what municipalities earn on invested reserves.

Higher bond yields also impact housing borrowing costs for both builders and individuals. Meeting housing targets depends on homebuilders being able to finance their cost of housing construction and, in many cases, meeting their financial obligations for funding infrastructure by paying development charges (DC). If economic or market conditions deteriorate, the willingness of banks to finance small builders and development companies may wane.

• If volatility in the bond market makes it hard for investors to plan, the same can be said for local governments:
• If high interest rates are anticipated to be a short-term prospect, the strategy may be to scope a near-term horizon and refinance when circumstances improve. Alternatively, officials might look to defer some capital projects and long-term borrowing until more favourable market conditions apply
• The yield curve may dictate moving ahead with projects funded by on-hand DCs or other reserves, or with debt, rather than investing in infrastructure on a more protracted schedule, as funds are accumulated over time
• Slower development can delay DC receipts and assessment growth after municipalities have invested in the enabling infrastructure. This can extend bridge financing and increase pressure on municipal cash flows. If development charge revenues arrive later than expected, the municipality still has to make its debt payments

Getting bond-market timing wrong can have serious real-life impacts at the local level.

Three Takeaways for Local Decision Makers

Bond market conditions should inform capital plans through an assessment of affordability, financing options, and cash requirements.

TAKEAWAY #1: RISK AND CAPITAL AFFORDABILITY

As the risk profile of debt increases globally, so does the “risk premium” expected by the market. Investors looking for low-risk fixed-income securities with competitive interest rates may see local debt as an attractive alternative to corporate or other public debt investment.

Canadian municipalities have some of the best financial risk profiles of any governments anywhere. They are required to balance their operating budgets, most have significant debt capacity, and are seen as unlikely to be allowed to default by their provincial governments.

However, the cost of borrowing for local governments will still rise in tandem with other public issuers of debt. In the case of municipalities, those debt-service costs must be paid by increases in property taxes and utility rates, changes to other spending, or revisions to the capital program.

TAKEAWAY #2: COMPETITION FOR CAPITAL

In an environment where the federal government and the provinces and territories are proceeding with very large, debt-financed infrastructure projects, the competition for credit may intensify. Private companies are also competing for capital.

Local authorities will need to anticipate that competition in the bond market and with conventional lenders. This may mean pooling debt-issuance or collaboration on borrowing, through such institutions as the Municipal Finance Authority of British Columbia, Infrastructure Ontario or the Canada Infrastructure Bank, to ensure scale and market access for smaller, more localized projects.

TAKEAWAY #3: INNOVATION IN FINANCING

Uncertain and fluctuating fiscal and economic conditions may be an opportunity for innovation in financial products and strategies.

Beyond traditional, taxable debenture debt, municipalities and other local and regional authorities may find merit in using other types of securities like promissory notes. They may also want to argue for legislation, commonplace in the United States, enabling tax-exempt infrastructure bonds or bonds supported by ear-marked revenues.

More extensive temporary use of committed reserve funds, secured by promissory notes or loan agreements, may add flexibility, particularly for shorter-term borrowing, smaller-scale, or shared-cost projects.

As with household mortgages, local authorities can build-in flexibility by shortening the term of debentures or altering their typical amortization periods. The trade-off is that shorter terms must be refinanced at future (possibly higher) rates, and shorter amortization periods mean higher annual payments.

The Bottom Line

Swings in the global bond market have impact beyond the financial markets. They affect municipal budgets and projects.

Although municipal councils approve capital plans, debentures, and debt-and-investment policies, under “strong mayor” legislation, the practical choices may be in the hands of the mayor/regional chair and their principal staff advisors. The municipal treasurer and the city manager/chief administrative officer need to understand and explain the options and their implications for tax rates and project timing.

Treasurers should review unissued debt, interest rate sensitivities, and cash requirements alongside their capital plans. Meanwhile, Councils should understand which projects, funding commitments, or repayment assumptions change when borrowing conditions change.