Differences between the returns of the various market sectors were muted in the month. Federal issues earned, on average, 0.42%. Provincial issues returned 0.60%, as provincial yield spreads edged wider and offset some of the benefits of their longer duration. Corporate yield spreads also widened by a basis point, and that sector gained 0.51%. Corporate new issuance at $6.9 billion in the month continued to trail the record pace of 2013. High yield bonds earned 0.93% and Real Return Bonds returned 0.85% in the month.

One noteworthy new issue in April was the first ever 50-year bond from the Government of Canada. The government had been considering an ultra-long issue for a couple of years and the recent rally appeared to be the deciding factor. The issue was initially expected to raise $750 million, but strong investor demand resulted in an increase in size to $1.5 billion. The strength in demand reflected more the demand for very long duration assets by pension funds and life insurance companies than the remarkably low 2.96% yield to maturity.

In April, geopolitical events appeared to dominate economic fundamentals in the minds of bond investors. In the long run, though, we believe that fundamentals are more likely to drive bond valuations. Late first quarter and early second quarter indicators are pointing to a significant acceleration in U.S. growth. Indeed, some economists are predicting U.S. GDP to increase at +3.6% or faster in the second quarter as the economy rebounds from the weather-induced slowdown in the first three months of the year. Should that acceleration occur, the U.S. economy would finally grow faster than the Canadian one. Canada’s economy has been remarkably resilient, growing faster than the U.S. in the final quarter of 2013 and likely in the first quarter of this year, but we think that outperformance is likely over.

More importantly, the key question is whether the U.S. economy can maintain that pace after the second quarter weather rebound. If it was able to grow at close to 3% for the next few quarters, the Fed might be forced to raise rates sooner than the consensus expectations of spring 2015. Unfortunately, it seems more likely that the growth rate will be somewhat slower and the Fed will not move sooner than expected.

In Canada, we believe that domestic demand growth is lukewarm. Export growth and acceleration in business have been disappointing to date, but need to accelerate if Canadian growth is to improve. Hence, our focus on the pace of U.S. growth. Notwithstanding the Bank of Canada’s balanced statements regarding the direction of future interest rate moves, we think it unlikely that there will be any reductions. Rate increases will probably only occur after the Fed has started raising U.S. interest rates. We continue to monitor Canadian inflation closely, as we suspect the Bank of Canada’s benign forecast for it may prove too optimistic. We are concerned that the decline in the exchange rate and recent agricultural developments may lead to a sharper than expected rise in Canadian CPI. As a precaution, we have started adding Real Return Bonds to the portfolios.

We believe the bond market rally this year has taken yield to unattractive levels. Accordingly, we are looking for opportunities to shorten durations further. Along the yield curve, 2 and 3-year bond yields are only slightly higher than money market rates, and we are therefore avoiding those terms. Corporate bonds remain our preferred sector, but yield spreads have become less attractive in recent months. Accordingly, we are looking for opportunities to modestly reduce the corporate sector overweight allocation.

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