Is the long-term corporate credit market disconnected from its fundamentals?

Canada’s long-term corporate bond spreads have tightened considerably since 2022, reaching historically low levels. The tightening is especially pronounced when we compare long-term corporate bonds and provincial bonds, whose average spreads are approaching their lowest levels since April 2007. In an uncertain economic environment fraught with geopolitical instability, tariff-related volatility, and inflationary pressure, we would instead expect risk premiums on long-term corporate bonds to go up.

The funding profile in Canada has undergone a major shift in recent years. Is it temporary or structural? Only time will tell. But the figures leave no doubt:

• The provinces have issued more than $50 billion above their historical trend, mostly to fund post-pandemic budget deficits, infrastructure, and social programs.

• Corporations have reduced their issuance by nearly $20 billion relative to their historical trend, amid higher financing costs, increased caution in an uncertain economic environment, and easier access to other sources of financing, such as accumulated liquidity, bank loans, and foreign markets.

This $70-billion net imbalance in the relative supply of long-term bonds is unprecedented since the 2008 crisis. With fewer corporate bonds available to investors and more provincial bonds outstanding, the imbalance creates a relative scarcity of long-dated corporate credit and in all likelihood has contributed to the historic credit spread compression seen since 2022.

Defined-benefit (DB) pension plans, which are strong proponents of liability-driven investing, have undergone a notable turnaround in recent years. After a decade of significant challenges caused by the 2008 financial crisis, such as actuarial deficits, contribution increases, and market volatility, their financial strength has greatly improved.

With a favourable combination of solid returns, higher interest rates, and excess contributions, many plans are posting actuarial surpluses. This context opens the door to a strategic reallocation of assets, particularly to long-term bonds, for three main reasons:

• Plan maturity

Many DB plans are maturing, with an increasing proportion of retirees relative to active members. As a result, they are reducing volatility and securing future cashflows, which encourages investment in long-term bonds.

• Accounting effect: A discount rate independent of allocation

Financial statements use a discount rate based on a reference curve composed of high-quality corporate bonds. The rate, which is independent of the portfolio’s actual composition, encourages plans to align with the curve to reduce accounting volatility.

• Solvency: A key criterion for annuity purchases

The yield curves used to assess solvency are partially based on high-quality corporate bonds, often combined with sovereign securities. A high discount rate reduces the value of future undertakings, improves the solvency ratio, and makes annuity purchases more accessible. This encourages plans to align their portfolios with the components of the solvency curve, including long-term corporate bonds, to reduce the risk of mismatch and facilitate the management of undertakings transferred to insurers.

Result: Increased demand for long-duration fixed income securities, particularly long-term corporate bonds, as plans seek a secure return and better asset-liability matching in a more favourable financial environment.

IFRS 17, which came into force on January 1, 2023, has profoundly changed the way life insurers value their liabilities. By redefining accounting parameters, IFRS 17 has created an incentive for them to increase their exposure to corporate bonds, particularly the long-term segment—a natural habitat for the industry.

This regulatory change acts as a structural driver of demand for long-term corporate credit. IFRS 17 hasn’t just changed accounting rules; it is also actively reconfiguring demand in the bond market, adding to the downward pressure on long-term credit spreads.