One of the items that received little attention in the federal government’s most recent Economic Action Plan (also known as the 2013 Budget) was a commitment to expand its issuance of long-term debt. This interesting tidbit was buried in the debt management strategy for 2013-14.
For those of you who don’t know, the debt management strategy sets out the Government of Canada’s objectives, strategy and plans for the management of its domestic and foreign debt, other financial liabilities and related assets. While the chief aim of the government is to prudently manage its liquidity position and borrowing costs on behalf of Canadians, there are very direct implications for investors (individuals and DB pension plans alike).
The federal government made adjustments to its debt management strategy 2012-13 in September 2012 following a sustained period of declining interest rates. The purpose of the change to the strategy was to lock in attractive funding rates by re-allocating short-term issuance towards long-term bonds. To achieve this, the government added an additional 10-year bond auction during fiscal year 2012-13, as well as an additional auction of 30-year bonds. Furthermore, the government telegraphed the markets at that time, that the size of the auctions of 10- and 30-year nominal bonds might be increased, depending on market conditions. In addition to holding more auctions, the government halted buyback initiatives of 30-year bonds.
The 2013-14 edition of the debt management strategy extends the “temporary” increase in 10- and 30-year bond issuance announced in September 2012. In attempting to achieve a more even distribution of maturities, 30-year bonds will rise to 29% of the stock of market debt over the next decade, up from their current 19%. As well, the government is assessing the potential benefits of issuing bonds with maturities 40 years or greater.
It’s worth noting that the United Kingdom, Japan and France already issue 40-year bonds and that most Canadian provinces have issued 40-year debts as part of their financing initiatives. In fact, Ontario, Quebec and Nova Scotia have debt issues with terms 50 years or greater. There is no mention of issuing additional real return bonds.
As has already been noted, long-term interest rates remain at historically low levels, and not just because the Bank of Canada has kept borrowing costs low. Foreign purchases of our long-term debt and increased use of liability matching strategies by pension plans are placing strains on what has been up to now a dwindling supply of long-term bonds.
So what does this mean for DB pension funds and individuals? Greater supply of long-term debt is positive for pension funds, both in terms of access and pricing. Many pension funds have already begun de-risking their investment strategy, which often means more bonds and more long-term bonds. Some pension funds are preparing their investment portfolios for annuity purchase when interest rates (and hence annuity rates) rise to more favourable levels. Having more longer-dated debt will assist plans in achieving their goals.
From a pricing perspective, more issuance will assist in driving up prices since some of the current supply/demand imbalance will be addressed. Higher interest rates are again positive for DB pension plans since the rate at which their liabilities are discounted will increase with rates. From an individual perspective, higher interest rates over longer periods is certainly positive. Many individual investors, especially retirees, have been pushed towards riskier assets in order to achieve sufficient income on which to live. Individuals will also find it easier to ladder their bond purchases so that maturities are more staggered.
In my assessment, I am assuming that the market reacts rationally and that long bond rates do rise as a result of increased issuance. Time will tell, but it appears this is a step in the right direction.