Performance by sector showed that, on a duration-adjusted basis, federal bonds were the best performing sector in the month. Provincial yield spreads widened an average of 3 basis points due to some investor selling and ongoing concerns about Ontario’s fiscal situation. Corporate bonds were hurt by the weaker economic data and their yield spreads widened an average of 4 basis points. Real Return Bonds underperformed nominal bonds, declining 0.44% in the period. Investors in RRB’s appeared to focus more on the drop in the annual rate of inflation to 1.9% from 2.6%, than on the 3-month pace of inflation that crept up to 5%.

For the next month or two, interpreting economic data will have increased challenges due to inaccurate seasonal adjustments. Typically, economic activity fluctuates in predictable ways throughout the year. Retail sales, for example, are particularly strong prior to Christmas, but fall sharply in January and February. Hiring and firing by retailers follow a similar pattern. In the educational sector, hiring rises in September and falls in June, while students seeking jobs can skew labour market data during summer months. Construction activity is typically weak in the winter months as bad weather interferes. Economists and government statisticians attempt to deal with these sorts of fluctuations by adjusting raw economic data for the usual, expected fluctuations. In applying seasonal adjustments to economic data, they hope to reveal the underlying trend of economic growth.

The extremely mild winter in 2012 is thought to have encouraged economic activity earlier than normal this year. Construction that in typical years would have commenced later in the spring could begin earlier in 2012. Fewer winter storms meant fewer than normal days lost due to weather. However, to the extent that activity increased in the first quarter due to the mild weather, it may subtract from the second quarter pace of growth. We will need another month or so of data to accurately discern the underlying pace of the economy.

Ultimately, though, we believe the Canadian economy will grow at a subdued pace for the balance of 2012. In large part, the pace of economic growth in this country will be dependent on that of the United States. Fortunately, we expect that U.S. growth will remain satisfactory. Indeed, if the U.S. housing sector has finally bottomed and is starting to recover (which we suspect), the resultant lift to U.S. growth could be substantial. Stronger economic growth should be positive for equities and somewhat negative for fixed income investments.

Adding to our cautious outlook for bonds is the upcoming conclusion of the Fed’s Operation Twist. Since last October, the U.S. central bank has been trying to stimulate the U.S. housing market by driving longer term yields lower. To do this, the Fed has been gradually selling $600 billion of U.S. Treasuries maturing in less than 3 years and reinvesting in longer term Treasuries. In June, Operation Twist will come to an end, and it is unlikely that the Fed will try to extend it unless the economy falters significantly. As a result, the yield of longer term U.S. bonds is expected to rise, and that should put upward pressure on Canadian yields.

While the underlying trend for the balance of 2012 should be a shift toward higher yields, we believe there is a strong likelihood of a short term rally in the Canadian bond market. In June, the various bond market indices will undergo unusually large duration extensions as large issues of bonds are dropped because their remaining terms to maturity will become too short for inclusion in the indices. It is estimated that the DEX Universe Bond index duration will jump 0.28 years in June, while the DEX Long Term index will increase 0.30 years. For index funds, and closet index managers, these increases will necessitate purchases of bonds to extend their portfolio durations by similar amounts. In addition, large coupon payments, primarily on government bonds, will need to be reinvested thereby causing additional demand for bonds. In anticipation of the rally, we have increased portfolio durations closer to their respective benchmarks. We have also reduced holdings of cash equivalents because they are no longer  required with the flattening of the yield curve. However, we remain cautious regarding short term bonds. Yields have been rising this year, but are still below the levels that existed prior to last summer’s crisis. Should the Bank of Canada in fact raise rates later this year, current 2-year Canada bond yields will quickly be surpassed by the Bank’s overnight target rate.

2-yr Canada Bond Yield

With a favourable economic environment and historically attractive yield spreads, corporate bonds remain our preferred sector. Notwithstanding the narrowing of yield spreads that has already occurred this year, corporate bonds remain attractive relative to all historical comparisons, save the post Lehman Bros. panic.

10-yr A-rated Corporate Bond Yield Spread

While we are optimistic about the corporate sector, we remain focussed on monitoring the credit quality of each holding in the portfolio. Our unique combination of top-down and bottom-up analysis is a significant aspect of protecting our clients’ capital. As well, we are prepared to respond promptly to any unexpected diminution in creditworthiness.

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