Since 2004, Canada has held a AAA rating from all major ratings agencies, but on June 24, it suffered a blow when Fitch Ratings Inc. downgraded the country to AA+.

“The rating downgrade reflects the deterioration of Canada’s public finances in 2020 resulting from the coronavirus pandemic,” said the Fitch in a rating action commentary statement. “Canada will run a much-expanded general government deficit in 2020 and emerge from recession with much higher public debt ratios. The higher deficit is largely driven by public spending to counteract a sharp fall in output as parts of the economy were shuttered to contain the spread of the coronavirus. Although this will support recovery, the economy’s investment and growth prospects face challenges.”

It’s likely that all Canadian pension funds have material exposure to government bonds, yet the Fitch downgrade in itself isn’t material, says Catherine Heath, vice-president and portfolio manager at Leith Wheeler Investment Counsel Ltd, noting it’s much more common for Canadian institutional investors to site Moody’s Investors Service and S&P Global Ratings in their investment policy statements, both of which have Canada at a AAA rating.

“Every institutional client, every pension fund, will have a policy statement that spells out what ratings need to be within the fixed income portion of their portfolio and they typically also are very clear about which rating agencies that would apply to,” she says.

While it’s rare to have a AAA-minimum rating requirement for fixed income, some investors do have that, she adds, noting the policy statement will say a AAA as indicated by Fitch, S&P or Moody’s. “But most of the time, it will say Moody’s and S&P rather than Fitch.”

In fact, Heath says, the majority of the time, policy statements specify an average of the ratings agency ratings. So while a Fitch downgrade wouldn’t be material, if another agency downgrades it would push down the overall average for Canada. “But again, I don’t think it would be very material because Canada is still regarded as a strong credit. And I think, even at a AA level, we wouldn’t have any issue with borrowing costs or financing.”

If Canada’s average did go down, the few portfolios that specify a AAA-rating requirement would be forced sellers out of Canada, she says.

Each rating agency has a periodic review process, but it could change a rating based on big changes in circumstances or their models. One possibility is that the other rating agencies will review Canada’s rating after the government presents an economic and fiscal snapshot on July 8, Heath notes.

Yet a review doesn’t necessarily mean a downgrade and it would be uncommon without putting the country on a negative watch first. “Sometimes they forgo that step if it’s clear that there’s not going to be that ability to improve in such a short period of time.”

Beyond investment policy implications, another potential impact of a rating downgrade is the cost of borrowing. However, Heath doesn’t expect material implications on this front.

She points to 2011, when the U.S. lost its S&P AAA rating, but maintained its AAA rating with the other agencies and didn’t see long-term consequences. “Borrowing rates are just so low and everyone . . . is in the same boat where ballooning deficits are something that is common across all industrialized countries.”

However, a difference between Canada and the U.S. is that the U.S. dollar is a reserve currency. “We wouldn’t benefit as much from that impact of international flow.”

When the Fitch downgrade was announced, the Canadian currency saw a slight impact, but it also coincided with Finance Minister Bill Morneau talking about extending the term of Canada’s debt, which also had implications for the dollar, Heath notes.

An extension to the duration of government borrowing would also have an impact on pension funds, she adds. “A lot of the COVID financing, or borrowing, costs have been borne by the short-end essentially and, with Morneau talking about moving that out to reduce interest rate risk, that starts to have consequences for . . . crowding out other borrowers.”

It also tends to have an impact on how the yield curve behaves, she adds.

Overall, the Fitch downgrade is more of a reputational issue than a financing or cost issue right now, Heath says. “But I think what this does do is it tars the reputation a little bit. It takes a bit of a shine off Canada’s pristine credit rating.”