The sharp decline in European yields to very low levels caused holders of those bonds to consider switching into other global alternatives. International interest in bonds of Canada and the United States, among other locales, accelerated in May as investors switched out of the European bond market. The flow of international investors into the Canadian and U.S. bond markets continued in August and, we believe, was a major factor behind the good bond performance last month. Interestingly, actual developments in Ukraine had less impact on the bond market in August. With equity markets, such as the U.S. S&P 500 stock index, hitting record highs and market volatility measures quite low, investors in general did not seem particularly concerned about geopolitics in the month.

The Canadian yield curve flattened in August as shorter term bond yields were unchanged, but 10 and 30-year yields fell 17 and 14 basis points, respectively. Apparently, investors felt that shorter term issues offered little potential gains, but longer term yields were viewed as attractive relative to European alternatives. The U.S. bond market provided some direction to the Canadian one in August, with longer term U.S. Treasury bonds experiencing even larger declines in yields than their Canadian counterparts.

The decline in longer term yields helped propel federal bonds to an average 0.91% return in the month. Provincial bonds earned an average 1.50% during August. Provincial yield spreads edged slightly wider, but the impact was more than offset by the longer average duration of provincial bonds that resulted in larger price gains as yields fell. Corporate bonds lagged government issues, rising only 0.77%, as their yield spreads widened 3 basis points. New issues were sparse in the month, totalling only $1.1 billion.Non-investment grade bonds declined 0.24%, leaving the year-to-date returns of high yield bonds little different than those of higher quality, investment grade issues.  Real Return Bonds gained 0.48%, as the decline in inflation in the month produced investor complacency.

An interesting development in the Canadian corporate sector was the takeover of Tim Hortons by Burger King. One of the motives for the purchase was to allow Burger King to shift its head office to Canada and, thereby, substantially reduce its corporate tax rate. However, in the process, Tim Hortons’ bonds would fall from a weak investment grade rating to junk status, as Burger King bonds are rated only B. The three Tim Hortons bond issues contain change of control provisions that requires the company to buy them back at a price of $101. However, because of the bond market rally this year, some of those issues were trading at substantially higher prices, and they fell sharply on the news of the takeover. The Tim Hortons bonds maturing in 2023, for example, fell roughly 4.5% in value on the Burger King news. We had avoided holding any Tim Hortons issues, because the company had changed its financial strategy last year to take on significantly more leverage, so there was no impact on any of our clients’ portfolios.

Robust economic growth in the United States and, to a lesser extent, in Canada will eventually force the respective central banks to begin raising interest rates. We believe that the Fed is likely to begin moving rates up in the first half of next year, perhaps as soon as March. Given financial markets’ outsized reaction to the Fed’s initial talk of tapering its bond purchases in spring 2013, we suspect that the Fed will avoid discussing possible rate increases until a month or two before they occur. Until that time, we expect Fed speakers to continue to talk down rates and yields. However, history suggests that investors will not wait for the Fed to disclose its intentions. Rather, U.S. bond yields are likely to move higher well in advance of the Fed actually starting to raise rates. Higher U.S. bond yields will likely cause Canadian yields also to rise. The Bank of Canada, in our opinion, will probably wait until after the Fed has increased U.S. rates two or three times. The Bank would like to see greater Canadian export activity and it needs a weaker, not stronger, exchange rate to accomplish that. Thus, it does not want to make Canadian fixed income securities relatively more attractive, and it will delay rate moves accordingly.

Portfolio durations are currently defensive, that is shorter than respective benchmarks. We continue to monitor economic fundamentals and as Fed interest rate increases become more imminent, we will reduce durations further. We also expect to shift away from mid-term issues as these will probably underperform when the market starts to anticipate rate increases. With regard to market sectors, corporate bonds continue to offer good value, but are less compelling versus government bonds than they have been since the financial crisis. Accordingly, we are looking to selectively reduce corporate exposure and increase provincial bond holdings.

1 2