On September 23rd, bank capital regulations will change. Issuance of senior deposit notes will no longer be allowed, and banks instead will have to issue debt with so-called bail-in provisions. In contrast with deposit notes that might have required a government bailout if the bank became financially distressed, holders of the new notes will share in the losses if the issuer falters, including potential conversion into equity. The new bail-in debt will, however, rank ahead of subordinated Non-Viability Contingent Capital (NVCC) notes in an insolvency and, therefore, will trade with narrower credit spreads. Outstanding deposit notes will likely trade with the tightest yield spreads. In the roughly three weeks until the regulation change, there may be substantial new deposit note issuance to replace the approximately $11 billion of outstanding deposit notes that mature before the end of the year. The Bank of Montreal already started the process by reopening a 10-year deposit note for an additional $1.25 billion in the last week of August.

As this is being written, the Bank of Canada has decided to leave its administered interest rates unchanged. In its statement the Bank said that it planned to continue raising rates gradually although it was paying particular attention to the impact of higher rates on economic activity and to the outcome of the NAFTA negotiations. In the United States, although president Trump has recently been criticizing the Federal Reserve for raising interest rates, we expect the Fed will continue its gradual series of 0.25% increases when it next meets on September 26th. While the Fed’s move is widely expected, it should provide some upward pressure on U.S. bond yields, particularly if the accompanying statement is at all hawkish.

Our outlook for bonds assumes that the current trade tensions do not escalate into a full-blown global trade war that leads to a recession. Specifically, we believe Canadian and American negotiators will be able to successfully conclude the renegotiation on NAFTA. While the threatened auto tariffs in the absence of a new agreement is a non-trivial risk, we do not think it the most likely outcome. However, we are monitoring developments closely and will make adjustments to the portfolio structure if they become appropriate.

We continue to believe that the current demand/supply imbalance of long duration bonds will correct in the next few months and long term yields will rise. In anticipation of that occurring, we are keeping the duration of the portfolio shorter than that of the benchmark. As well, we have structured the portfolio to benefit from increasing term differentials (i.e. a steepening of the yield curve).

 

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