Global bond markets declined in May as investor concerns about the monetary easing programmes in Japan and the United States led to sharp increases in yields and declines in prices. The yield on 10-year US Treasuries surged a remarkable 49 basis points in May, while 10-year Japanese Government Bonds rose from 0.61% to 0.85%, having traded briefly as high as 1.00% during the month. Other bond markets reacted with similar moves; yields on 10-year U.K. Gilts and German Bunds rose 31 and 21 basis points, respectively. Canadian bonds were not immune from the volatility and, as a consequence, experienced their worst monthly returns of the year. The DEX Universe Bond index declined 1.46% in May.

In Japan, investors lost confidence in Prime Minister Abe’s and Bank of Japan Governor Kuroda’s plan to raise Japanese inflation to 2% by the end of 2014. In particular, the Bank of Japan gave mixed signals about providing sufficient stimulus, and that led to a reversal in the Yen’s weakening trend and also to an 11.9% swoon in the Nikkei stock index late in the month. In the United States, the key development was the discussion by Fed Chairman Bernanke and a number of other Fed officials about the potential reduction in the size of the Fed’s Treasury and MBS purchases if future economic data warranted it. While Bernanke and some of his colleagues stressed that a reduction, or tapering, of the purchases was not appropriate at the present time, investors seized on the possibility that tapering was imminent. Currently, the Fed purchases $40 billion of mortgage-backed securities and $45 billion of Treasuries per month and even a gradual tapering of those amounts might tip the demand/supply balance. Bonds sold off as investors anticipated this change and tried to get ahead of it.

The downdraft in US Treasuries was exacerbated by selling to offset the negative convexity of residential mortgage portfolios. In other words, as yields rose, slowing prepayment assumptions caused the durations of mortgages to increase, making them more sensitive to further increases in yields. In the United States, most mortgages have 30-year maturities, but are pre-payable at the homeowner’s option. Mortgage investors anticipate that some mortgages will prepay early, with the rate of prepayments correlated to the differential between the mortgage interest rate and the current rate for new mortgage loans. As rates fall, mortgage borrowers have greater and greater incentives to re-finance at lower rates and thereby reduce their costs. As a result, mortgages are repaid more rapidly and investors have to purchase bonds to offset the shortening duration of the mortgage portfolios. When rates increase, the converse occurs. There is less incentive to prepay and the expected duration of mortgage portfolios increases. Investors often offset the increase in mortgage durations by selling bonds such as US Treasuries. In May, it was estimated that a 25 basis point increase in mortgage rates would lead to selling of the equivalent of $145 billion of 10-year US Treasuries. In essence, the initial selloff in bonds caused further selling as mortgage investors tried to reduce the impact of rising yields on their portfolio durations.

In the United States, economic news during May was mixed and did not appear to be the source of the bond market weakness. On the positive side, unemployment fell to 7.5% from 7.6% as job creation was faster than expected, and consumer confidence was sharply higher due to record stock market levels and rising house prices. On the other hand, both manufacturing and service sectors decelerated and industrial production was disappointing. Retail sales showed tepid growth, auto sales contracted slightly, and personal income growth was weak. In the housing sector, starts of new homes faltered slightly, but prices continued to recover. Surveys released in May showed that average prices rose almost 11% in the last 12 months. (Even with that increase, prices remained 26% below the peak reached prior to the financial crisis.) The upward trend in home prices is noteworthy because it would improve consumer confidence and spending. It would also result in fewer homes having mortgages larger than the current value of the home, which should improve labour mobility as it reduces the disincentive to move to better jobs.

Canadian economic news was also mixed in May. Unemployment held steady at 7.2% as job creation was moderate, but higher-paying full time jobs replaced lower paying part-time positions. First quarter growth in Canadian GDP was stronger than expected, but most forecasts of second quarter growth anticipate some deceleration. Housing starts slowed somewhat and retail sales failed to grow in the most recent month. Inflation remained non-existent, with CPI actually falling on a monthly basis and declining on an annual basis to 0.4% from 1.0%.

The Canadian yield curve steepened in May, as 30-year bond yields rose 26 basis points while 2-year yields increased only 16 basis points. Mid-term bonds were actually the worst hit sector in the selloff, with 5 and 10-year yields climbing 32 and 37 basis points, respectively. Federal bonds declined 1.47% in the month, in line with the overall index. Provincial bonds fell 1.87% as their longer average durations meant that they experienced larger price declines as yields rose. Losses on provincial bonds were mitigated by sharply tighter yield spreads, however. Provincial yields narrowed to Canada yields by an average 7 basis points in the month. Investment grade corporate bonds returned -1.02% in the period. Even though there were $10.8 billion of new corporate issues in May, yield spreads narrowed an average 5 basis points as demand remained strong. In part, that demand reflected the need to reinvest coupon payments expected at the start of June. Canadian high yield bonds gained 0.79% in the period, as spreads narrowed approximately 40 basis points. That performance was in stark contrast to US high yield bonds which actually widened slightly in spread during May and declined an average 2.28% in the month. Real Return Bonds plunged 4.71% in May, as the drop in CPI reduced demand for inflation protection. RRB’s were also hurt by their relatively long durations when yields rose.

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