The trade war is set to plunge Canadian provinces into deeper deficits, revitalizing a sleepy corner of the credit market.

Provinces are expecting wider deficits and higher funding needs, which means selling more bonds. The seven provinces that have proposed budgets so far reported a combined deficit of $32 billion for the 2025-2026 fiscal year, double the estimates for the year prior, according to a note from National Bank of Canada.

Quebec and Ontario are most exposed to a trade war because of their large deficits and significant ties with the United States, said Douglas Offerman, senior director at Fitch Ratings Inc. Ontario hasn’t submitted a budget yet for 2025-2026.

The market is adapting. Provincial issuers are boosting deal sizes and extensively pre-funded for the fiscal year that began Tuesday, said Sameer Rehman, managing director and head of government finance at Bank of Montreal. Seven provinces, including Ontario, planned to raise nearly $30 billion in pre-borrowing for 2025-2026. That’s more than quadruple the $6.7 billion pre-borrowed the year prior, according to financial services firm Desjardins Group.

Bond dealers are mitigating their risks by compressing the time between building the book — gathering orders and assigning allocations — and completing the sale of the bonds, Rehman said. And the underwriting banks are boosting trading in the secondary market, he said.

So far, investors are receptive. Demand has risen to meet supply as the market gets more robust, and the risk premium for provincial bonds has generally remained tight compared with Canada’s federal debt.

Canadian provinces borrowed a record $51 billion equivalent from offshore markets in 2024, up from $18.6 billion in 2023, according to data from RBC Capital Markets. Increased access abroad could help prevent them from flooding the domestic market if debt needs balloon.

Provinces tend to benefit from a flight to quality because investors are drawn to their liquidity, prudent fiscal discipline and broad taxation authority, said Travis Shaw, senior vice president at Morningstar DBRS, which currently has all provincial rating trends at stable.

Most provinces have flexibility within their existing ratings to endure somewhat larger deficits and rising debt in the near term, Shaw said. But that headroom could shrink as the trade war wears on.

—With assistance from Mathieu Dion.

Bloomberg.com