For most of July, politics rather than economics dominated the bond markets’ attention. Dithering by European leaders over another aid package for Greece and other bailed-out countries prompted concerns that it was insufficient to stop the sovereign debt crisis from spreading. In particular, the prices of bonds issued by Spain and Italy fell sharply and their yields moved higher. A second major political debate affecting the market was the U.S. debt ceiling negotiations that dragged on to the 11th hour. The poisonous, polarized political atmosphere in Washington threatened the United States’ AAA rating and raised the spectre of a default on its debt. International investors, seeking to protect their capital in light of both of these crises, were attracted to Canada’s better fiscal and economic situation. Robust foreign demand for Canadian bonds, especially those issued by federal and provincial governments, pushed bond prices higher and yields lower. The Canadian bond market also received support from faltering economic data, weak equity markets and a surprisingly strong U.S. Treasury market. The DEX Universe Bond index returned 2.04% in July, the strongest monthly gain since December 2008.

Canadian economic data was mixed. On the positive side, housing starts and retail sales were somewhat stronger than expected. International securities transactions for May confirmed that net foreign buying of Canadian bonds was robust at $11.1 billion. Unemployment held steady at 7.4%, with 28,400 new jobs created. Inflation unexpectedly fell to 3.1% from 3.7% the month before, as the prices of new cars and gasoline each fell sharply. On the negative side, Canadian GDP declined 0.3% in May. While the mining and oil and gas extraction sectors were particularly weak due to wildfires in Northern Alberta as well as routine maintenance shutdowns, other parts of the economy also experienced slower than expected growth. The manufacturing sector was impacted by the strong Canadian dollar, weak U.S. demand, and supply problems caused by the Japanese earthquake and tsunami.

The Bank of Canada left its overnight interest rate unchanged, but removed the word “eventually” from its description of the timing of its next rate hike. Most observers interpreted the change to mean that the Bank anticipated raising rates before the end of 2011. Subsequently, though, Bank Governor Mark Carney stated that the Bank was more concerned by external developments such as weaker global economic growth and the European sovereign debt crisis than current domestic economic conditions. He also suggested that, in the current environment, “neutral” monetary policy might occur at lower rates than in the past and might not be reached until after the economy was operating at full capacity. That implied the pace and number of rate increases might be less than market expectations.

In the United States, most of the economic data received in the month confirmed that growth had slowed significantly. Unemployment rose to 9.2% from 9.1%, as only 18,000 net new jobs were created. Importantly, the estimate of job creation for the previous month was also revised down to only 25,000. With the U.S. economy needing approximately 150,000 new jobs every month to offset the growth in the labour force, the lack of job creation in the last two months was worrying. The weak jobs market was partly responsible for an unexpected drop in car and light truck sales. Also of concern was the lack of momentum in the economy. Late in the month, the estimate of second quarter U.S. GDP growth was revised from a 1.8% pace to only 1.3%. At the same time, the measurement of GDP growth in the first quarter of 2011 was slashed from 1.9% to only 0.4%. Thus, economic growth in the first six months of the year averaged only a 0.8% pace, far too slow to dig the United States out of its recessionary predicament. Inflation held steady at 3.6%.

The Canadian yield curve flattened slightly in the month, as the 25 basis point decline in 30-year bond yields exceeded the 20 basis point decline in 2-year yields. Interestingly, mid-term issues outperformed both short and long term ones as 5 and 10-year yields fell 34 basis points. Governor Carney’s remarks about the possible slower pace of rate increases appeared to cause investors to re-evaluate mid-term bond yields. The shifts in the Canadian yield curve were quite close to those that occurred in the U.S. yield curve. That U.S. bond yields fell so much was somewhat surprising given the ongoing discussions of a possible U.S. default, as well as the absence of any Federal Reserve bond purchases because its quantitative easing programme had ended.

Provincial bonds were the top performing sector, returning 2.59% in July. The good result was due entirely to the longer average duration of provincial issues, because their yields actually widened versus benchmark Canada bonds by an average of 3 basis points in the month. Corporate bonds earned 2.11% in the period, helped by a slight 2 basis point narrowing of yield spreads. New corporate issuance totalled $5.5 billion, but was concentrated in relatively few issues, which allowed spreads to narrow. The largest deals came from the Royal Bank, Bank of Montreal, and TD Bank as they raised a total of $4.3 billion of deposit notes. Canada bonds, as a sector, lagged provincial and corporate bonds, earning 1.68%. Real Return Bonds substantially outperformed nominal issues in the month, gaining 4.89% on average. The rally in nominal bonds helped, but RRB’s also gained because investors thought central bankers were less likely to counter inflationary pressures in the current environment. The unexpectedly large drop in the Canadian inflation rate failed to sway investors concerned that inflation would stay well above Canada’s long term 2% target.

For several months, we have been defensive regarding bonds, because we believed that yields were not reflecting the improving economic environment and the rising inflationary risks. Notwithstanding slower economic activity in the second quarter which appeared to stem mostly from temporary circumstances,, the recent upward move in bond prices and the fall in yields seemed to be mainly the result of large scale foreign buying of Canadian bonds, rather than a change in the economic outlook. The failure to adequately resolve the European sovereign debt crisis, as well as the U.S. debt ceiling debate prompted global investors to seek a safe haven in Canadian bonds. As yields on benchmark Canada bonds fell below the rate of inflation in this country, it became clear that many investors were buying bonds not for their prospective return but to preserve the investors’ capital. Low risks of default and/or devaluation were more important considerations than the price paid or the yield to be earned.

Fundamentally, bonds are expensive are expensive at current yield levels. While low, single-digit, positive returns are better than the losses of other asset classes, we believe it is prudent to reduce the risk within the bond portfolio. One reason that we think bonds are overvalued are their low absolute yields. As can be seen in the chart below, yields on long term Canada bonds are approaching levels last seen in 1951! Yield on Long Term Canada BondsA second reason for concern is that yields of most maturities of Canada bonds are now below the current rate of inflation. In other words, investors are losing money after inflation. The experience of the 1970’s and early 1980’s shows that while investors may temporarily accept negative real returns, they will eventually demand better returns and that will force yields to rise. A third reason for believing bonds are expensive is that they are benefitting from very stimulative monetary policy that will eventually need to tighten. When that happens and the Bank of Canada raises interest rates, bond yields will rise.

So, how long can the bond market continue to rally? That is difficult to predict, but to us the recent move appears similar to the rallies that occurred in the spring of 2003 and the fourth quarter of 2008. In the former case, many investors and economists were convinced that deflation was about to begin in the United States and bond prices surged higher for several weeks before retreating sharply and erasing all of the previous gains. In the latter example, investor panic and illiquid market conditions resulted in a rapid spike up in bond prices that was reversed in the subsequent four to five months. Investor psychology often turns quickly, and we believe that will likely be the case this time.

In terms of portfolio structure, we are maintaining durations that are shorter than the benchmark in anticipation of rising yields. We recognize, though, that the market may rally more before selling off, so we have not yet shifted the duration to the minimum permitted. When the Bank of Canada does begin raising rates, that will cause the yield curve to flatten and the portfolios hold significant money market and floating rate note positions as a hedge against the impact of that shift. The portfolios hold substantial amounts of corporate bonds, but have capacity to add as attractive opportunities arise. The portfolios also hold a meaningful position in Real Return Bonds as a hedge against inflation remaining high. Because we believe that nominal yields rising may lead to higher real yields, we are using relatively short RRB’s to gain the inflation protection.