The Canadian bond market remained range bound during March. Bond prices and yields were little changed as investors tried to divine the long term implications of the Russian annexation of Crimea and potential rate increases by the U.S. Federal Reserve. Discerning underlying economic growth remained challenging as data continued to be affected by the severe weather of this winter. The FTSE TMX Canada Universe Bond index returned -0.19% in March, resulting in a gain of +2.77% for the first three months of the year. Long term bonds did especially well in the quarter, earning +5.12% and roughly matching equity market returns in both Canada and the U.S.

Canadian economic data received during March confirmed the slow growth pattern of recent months. The unemployment rate held steady at 7.0%, as a drop in the participation rate offset a decline in the number of jobs. Capacity utilization continued to recover from the Great Recession, but is still below pre-crisis levels. International investment in Canadian bonds declined again; in the most recent 12 months, there was only $14 billion of net buying, much less than the $79 billion of net purchases a year earlier. Canadian inflation for the month of February was slightly above expectations, resulting in a smaller than forecast decline in the annual rate to 1.1% from 1.5%. Not surprisingly, the Bank of Canada left interest rates unchanged at its March meeting, although its accompanying statement was slightly less dovish than expected.

In the United States, economic news tended to be positive in March. Job creation, industrial production, consumer confidence, and personal income and spending were all stronger than forecast, suggesting a quick rebound from the weather-induced slowdown earlier in the year. Less positively, U.S. housing data leveled off in March. Sales of new and existing homes, as well as starts, failed to show any improvement, raising concerns that the sector’s recovery has stalled. Whether the weather was the sole cause of the levelling off of housing will take a couple more months’ data to determine.

As expected at its March meeting, the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve continued to reduce its bond purchases, lowering the monthly target to $55 billion from $65 billion. Investors were caught off guard, however, by remarks from Janet Yellen, the new Chair, at a press conference that followed the FOMC’s announcement. When asked about the possible timing of the first interest rate increase, she said it could happen as soon as six months following the end of the quantitative easing programme. With many observers expecting the Fed to wind up its quantitative easing by October, Yellen’s remark implied that interest rates could be headed higher in just over a year. That was sooner than many investors had previously expected, and it led to a quick selloff in bonds as investors adjusted their forecasts. It also led to mid-term bonds underperforming as investors anticipated the yield curve flattening. Bonds maturing in 5 and 10 years were sold, with the proceeds reinvested in long term bonds as investors anticipated that mid and long term yields would move closer together in coming months.Falling longer term yields

Internationally, the annexation of Crimea by Russia caused a brief flight-to-safety bid for bonds that dissipated by month end. Longer term, the West’s sanctions against Russia may reduce global economic growth slightly, but are not likely to have a meaningful impact on the bond market. The international development in March that may have longer lasting significance for investors was the Chinese decision to permit a domestic bond default for the first time. Until March, the Chinese government had always bailed out companies in financial difficulties before they actually defaulted. Last month, however, the government signalled that it would not step in when a solar panel manufacturer indicated that it could not meet its financial obligations. In doing so, the Chinese government was apparently trying to rein in the “shadow banking” sector, and force lenders to be more disciplined. The concern for global investors was that there might be a cascade of defaults of other Chinese bonds that would somehow lead to a financial crisis similar to the one that developed following the Lehman Brothers failure in 2008. The relatively small size of the potential defaults and the lack of interconnections between the Chinese bond market and the global markets suggest this risk is rather small, however. Instead, investors appear optimistic that the Chinese government will announce a series of measures to stimulate the economy following a spate of weak economic indicators in recent months.

The Canadian yield curve flattened modestly in March, as shorter term yields rose slightly more than longer term ones. Yields of 2-year Canada bonds, for example, rose 7 basis points, while 30-year yields increased only 1 basis point. The pattern of changes in Canadian yields followed fairly closely the changes in U.S. Treasury yields during the month. The federal sector returned -0.21% in March, as the increases in yields caused prices to decline. The provincial sector returned -0.48% in the period. Provincial yields widened versus benchmark Canada yields by an average of 3 basis points, thereby causing more significant price declines. Corporate bonds earned +0.13% in the month. Investor demand for the additional yield of corporate issues caused corporate spreads to narrow by 2 basis points on average. Real Return Bonds earned 0.30% in March.

In late March, the first “green bond” in Canada was issued, a 3-year TD Bank deposit note. Green bonds are similar to traditional bonds but their proceeds are used exclusively for new and existing projects with environmental benefits.  Internationally, green bonds were first issued in 2007 and a total of $24 billion are currently outstanding. As such, they make up only a very small slice of the $95 trillion global bond market. Supra-nationals (e.g. World Bank and European Investment Bank), federal and local government agencies, commercial banks, and private corporations have issued green bonds. There is, as yet, no consensus regarding key aspects of green bonds, such as the definition of green projects, the use of proceeds and reporting. The Canadian investment dealer community, though, is excited about this “new” product and hopes that there will be steady supply of green bonds to sell. Their expectation is that green bonds will attract untapped sources of private capital. It remains to be seen, though, whether sufficient demand for socially responsible investments results in relatively lower yields for borrowers. We will be monitoring developments in Canadian green bonds, but will only participate in them if they have the potential to perform at least as well as other issues.

Looking ahead, the bond market is likely to remain within the range it has established for the last few months until greater clarity is available on the underlying strength of the Canadian and U.S. economies. As well, interpreting upcoming U.S. economic data may be more challenging by the assumptions U.S. statisticians are making regarding Obamacare, the U.S. health insurance initiative. Those assumptions are both large and unproven, and may result in substantial revisions to economic data. Ultimately, though, we believe that bond yields will move higher as economic growth shakes off the effects of the severe winter storms and accelerates. Canadian growth may lag that of the United States, but we should still benefit from the increased activity of our largest trading partner. As well, the impact of the decline in our exchange rate and the resultant improvement in Canadian exporters’ competitiveness should become more noticeable in the coming months. Accordingly, we are remaining defensive regarding bonds, with portfolio durations well below the benchmarks.

Our preferred sector remains corporate bonds. At this stage of the economic cycle, creditworthiness in general is good and the additional yield is attractive. We are mindful, however, that yield spreads are approaching historical norms so the risk/reward trade-off is becoming less compelling. Should corporate yield spreads narrow much more in the coming months, we will look to reduce the allocation to that sector. Along the yield curve, we believe the best values are found in mid-term issues, as well as bonds maturing in 10 to 20 years. Shorter term issues, specifically those maturing in 3 years or less, are unattractive because their yields are simply too low. Should growth accelerate as we expect, we believe investors will begin to anticipate potential central bank rate increases and that will lead to higher short term bond yields (and lower short term bond prices).