The Canadian bond market treaded water in the first half of April, but declined with increasing intensity in the latter half of the month. In large part, the pullback reflected a global bond selloff, with European bonds leading the way down. As well, it appeared increasingly likely that the Bank of Canada would not lower interest rates again and that caused investors to adjust their assessments of fair value for bonds. The selloff late in the month was also exacerbated by rate-lock selling in Canada and the United States as corporate issuers tried to lock in low yields for future issues. (In a rate-lock, a prospective corporate bond issuer sells government bonds in advance of its own issue in order to “lock in” most of its funding costs. At the time of the issue, the corporation buys back the government bonds and sells its bonds at a yield spread versus the government benchmark.) As a result of the selloff, the FTSE TMX Canada Universe Bond index returned -1.36% in April.

Canadian economic news during April was mixed. The unemployment rate was unchanged at 6.8%, but there was a shift from full-time positions to poorer paying part-time jobs. Housing starts rebounded from weather impacted levels the month before, but manufacturing and wholesale sales were much weaker than forecasts. Inflation was higher than expected, rising to 1.2% from 1.0% and the core rate, which is supposed to be a better indicator of underlying inflationary pressures, jumped to 2.4% from 2.1%. The price of oil recovered somewhat with WTI moving from US$47.60 to US$59.63, a 25% increase in the month. That, in turn, led the Canadian dollar to rally from US 78.8 cents to 82.8 cents. The Bank of Canada left interest rates unchanged, but its subsequent communications convinced many investors that another rate cut was less likely.

The federal budget was released in April and contained a small change that may have some impact on the bond market in coming months. The budget announced that total return swaps that were dividend rental schemes would have to end effective October 31st. Dividend rentals involved pension funds entering into total return swaps with banks in which they received the total return of the S&P/TSX equity index in exchange for a relatively low floating rate of interest (say, CDOR – 5 basis points). The banks that were the counterparties to the total return swaps would hedge their exposure to the stock market by holding equities, but their motivation was tax arbitrage. They received dividends tax free from their hedges, but when they provided the total return to the pension funds, they claimed the payments as tax-deductible interest. (The pension funds are indifferent to interest or dividends because they don’t pay income tax.) The pension funds hedge their floating rate obligation by entering into asset swaps in which they buy a fixed rate bond and then, using a second interest rate swap, convert its return into a floating rate that is higher than what they have to pay in the total return swap. Thus, the pension funds are able to achieve equity returns of the S&P/TSX index plus 0.50% or more. That was sufficient incremental return to encourage the creation of several billion dollars of these transactions. If, however, these schemes are no longer permitted, the demand for bonds to asset swap will evaporate, which will be negative for the bonds. It remains to be seen whether the government will stick to the October 31st deadline or provide a longer implementation period.

Economic data on the U.S. economy during April was mixed, but on balance weaker than expected. The unemployment rate held steady at 5.5%, but job creation was much slower than in recent months and the participation rate fell again. The appreciation in the U.S. dollar over the last year and the drop in energy prices appeared to weigh on business investment spending; orders for capital goods excluding aircraft fell for the seventh consecutive month. Weak investment spending and a larger trade deficit were the primary factors underlying a weaker than expected 0.2% growth rate in U.S. GDP during the first quarter. The Federal Reserve left interest rates unchanged in April and its statement suggested that further improvement in the labour market would be necessary before it would begin raising rates. However, the bond market ignored both the weaker economic data and the implication that the Fed would not tighten monetary policy as soon as expected, as bond yields moved higher and prices lower.

Notwithstanding the continuation of quantitative easing by the European Central Bank and the ongoing Greek debt crisis, European bond yields reversed course higher in April. For example, German bond yields initially moved lower in the first half of the month, hitting all time record lows. Subsequently, though, Bund yields moved sharply higher and that selloff caught international investors’ attention, resulting in weakness in North American bond markets, too. Investors appeared to focus on the very low absolute yields of Bunds, negative comments from yet another well-known market pundit, and slightly better German inflation data.

Yield of 10-Year German Bonds

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