3.4 Provincial & Municipal Debt and Strip Bonds

Below the federal government, provinces and municipalities are major borrowers, and dealers also create zero-coupon strip bonds from government issues. This section covers provincial and municipal debt and the features, pricing and taxation of strip bonds.

Provincial and Municipal Debt Securities

Provincial Debt Securities

Canadian provinces have extensive responsibilities under the Constitution (healthcare, education, transportation) and finance capital expenditures by issuing provincial bonds. Provincial bonds are second only to federal debt in credit quality.

• Direct Issues: Bonds issued directly in the name of the province. They are secured by the province's consolidated revenue fund and backed by the full taxing authority of the provincial legislature.
• Guaranteed Issues: Debt issued by provincial Crown corporations (such as Hydro-Québec, Ontario Power Generation, or provincial financing authorities) that carry an unconditional provincial government guarantee. The province guarantees to pay both principal and interest if the Crown utility defaults.
• Credit Spreads Among Provinces: Because provinces cannot print currency to service debt, their borrowing costs vary based on debt-to-GDP ratios, economic diversification, and fiscal deficits. Resource-dependent provinces (e.g., Alberta, Saskatchewan) face yield spreads that fluctuate with commodity cycles, while diverse economies like Ontario and British Columbia historically command tighter spreads.

Municipal Debt Securities

Canadian municipalities (cities, towns, counties, regional districts) issue fixed-income instruments known as municipal debentures to build local infrastructure like bridges, transit networks, water purification plants, and schools.

• Credit Quality and Provincial Oversight: Canadian municipal debentures enjoy strong credit standing because:
  1. Debentures are backed by the municipality's general property tax base.
  2. Canadian municipalities are legally prohibited by provincial statute from running operating budget deficits.
  3. Provincial legislation limits how much municipalities may borrow (for example, Ontario caps annual debt servicing through an annual repayment limit), and some provinces require provincial approval for certain long-term borrowing.
• Structures of Municipal Debt:
  • Serial Debentures: The bond issue is subdivided into distinct maturity tranches (e.g., $2 million matures every year for 20 years). This retires principal gradually over time as the financed infrastructure is utilized.
  • Installment Debentures: Structured like a blended mortgage, where equal annual payments combine both principal and interest over the life of the debt.

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Strip Bonds (Zero-Coupon Securities)

A strip bond (or zero-coupon bond) is created when an investment dealer buys a block of high-grade Government of Canada or provincial bonds, deposits them with a central depository (such as CDS Clearing and Depository Services Inc.), and physically or electronically separates the bond into two distinct components:

1. The Coupons: Each individual semi-annual interest payment is stripped into an independent zero-coupon security that matures on that specific coupon payment date.
2. The Residual: The final principal repayment at maturity is stripped into an independent zero-coupon security that matures on the bond's final maturity date.

Investment Characteristics of Strip Bonds

• Deep Discount: Strips pay no ongoing coupon interest; they are purchased at a deep discount to par and mature at 100% of face value.
• Zero Reinvestment Risk: In a conventional coupon bond, an investor faces the risk that semi-annual coupon payments must be reinvested at lower yields. Because strip bonds pay no cash flows prior to maturity, reinvestment risk is completely eliminated. The compound yield to maturity quoted at purchase is locked in.
• High Duration and Volatility: Because all cash flows are concentrated at final maturity, a strip bond's duration equals its maturity. Consequently, strip bond prices are extraordinarily sensitive to interest rate fluctuations, exhibiting far higher percentage price swings than coupon-bearing bonds of the same term.

Taxation of Strip Bonds

Under CRA rules, the annual growth in value of a strip bond (the imputed compound interest) must be calculated and declared as taxable interest income annually, even though no cash is received prior to maturity. This represents another classic case of phantom income, making strip bonds ideal for tax-sheltered vehicles (RRSPs and TFSAs).

Government Debt Instrument Summary

Worked Example: Pricing a Strip Bond

A strip bond's price is simply the present value of its single payment at maturity. Suppose a 10-year Government of Canada strip with a $100 face value is priced to yield 4.00% compounded semi-annually:

$P = \frac{100}{(1 + 0.04/2)^{20}} = \frac{100}{1.485947} = 67.30$

The investor pays about $67.30 per $100 of face value and receives $100 at maturity. If the yield instead rose to 5.00%, the price would fall to $100 / 1.025^{20} = 61.03$, a drop of about 9.3%, which illustrates how sensitive long strips are to interest rates.