We continue to believe the recovery will be slow and prolonged. Unemployment is high but has had limited impact on consumer spending because of temporary government aid programmes. When those programmes wind down, spending will likely be negatively impacted. If we are correct in expecting growth to be disappointing, the Bank of Canada is likely to keep interest rates at the current, extraordinarily low levels for two years or more. While we believe the Bank will eschew negative interest rates (because they are not effective and have unintended negative consequences), holding its overnight interest rate at its lower bound will keep shorter term bond yields very low. Longer term yields may fluctuate according to the level of optimism regarding successful development of a vaccine as well as investor indifference to massive fiscal deficits. In the near term, we believe bond yields are not likely to change much, staying in a trading range.

With corporate yield spreads close to pre-pandemic levels, we do not believe they are properly discounting the economic and financial risk in the current environment. We are concerned that personal and corporate bankruptcies may soar when loan payment and rent deferral plans end, and bank earnings will fall sharply as a consequence. We suspect declining bank earnings or a correction in equity markets may be the trigger to corporate yield spreads widening again. Canadian banks reported quarterly earnings in late August, and provisions for credit losses were increased somewhat although actual losses remained low due to temporary payment deferral schemes. We expect a better sense of the severity of potential losses will come following the cessation of the deferral plans.

Rather than trying to time when the market will focus on declining earnings, we prefer to be more conservative by shifting to higher quality issues and reducing lower rated issues such as BBB-rated bonds. In the short run, we may give up some yield by focussing on higher-rated issues, but elevated risk levels make that the appropriate strategy.

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