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What a credit downgrade means for Canada

Investments, Off the Cuff

Posted by Geoff Johnston

Jul 3, 2020 10:00:00 AM

Senior Portfolio Manager
Empire Life Investments Inc.
Gestionnaire principal de portefeuille
Placements Empire Vie

Off the Cuff video with Geoff Johnston

In this Off the Cuff video, Geoff Johnston discusses the recent credit downgrade for Canada.



As you may have heard, the credit rating of the Government of Canada was just downgraded by Fitch Ratings from AAA to AA due to concerns about Canada’s rising debt and deficit levels.

Many investors are very concerned about what this means for their Canadian investments, especially Canadian bonds. The biggest question they have is about Canadian borrowing costs. Is this downgrade going to cause an increase in borrowing costs?

We don’t believe Canada’s federal debt situation is nearly as bad as it seems.

For starters, Canada has only been downgraded by one rating agency and that is Fitch. The big ones are S&P, Moody’s and, in Canada, DBRS. All these rating agencies still rate Canada AAA. Granted, Fitch could simply be the start of a trend and other rating agencies could follow suit. But even the consequences to our borrowing costs should be minimal, and this is the main point I want to get across here:

Canada is the sovereign issuer of its own currency. In other words, the Canadian government debt is almost entirely in Canadian dollars, which it controls. What does this mean? It means that the Canadian government could pay off all its debt tomorrow in one giant Quantitative Easing (QE) program.

Won’t this cause inflation? No. If QE caused inflation, we would have it by now. In fact, we have deflation based on the latest stats. The reason why QE doesn’t cause inflation is that it is basically just a swap of cash for bonds. There is no increase in overall financial assets in the system. For example, if you had $10,000 worth of Canada bonds and I was the Bank of Canada, you would give me the bonds and I would give you $10,000 in cash. Would you be better off? No, your assets would still be $10,000. The only difference is that now you have cash instead of bonds. You are no richer and your spending power has not increased. This is why QE does not cause inflation.

The bond market is well aware of this. This is why our bond yields remain very low with 10 years at 50bps and our 30 year bond is below 1.00% - which is actually lower now than before the downgrade! A similar situation happened in the USA. When they were downgraded in 2011, bond yields fell afterwards.

Lastly, Japanese debt levels are far higher than ours. I believe Japan’s debt/GDP ratio is north of 200% versus less than 100% for Canada. Yet, their bond yields are zero because they are also a sovereign debt issuer.

The bottom line is that Canada’s debt situation is not as bad as it seems. There are plenty of things to worry about these days, especially health-wise, but Canada’s credit worthiness is not one of them, or at least it should be far down the list of concerns!

I hope this helps. Thanks for listening and good luck out there.

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June 29, 2020