As we move into 2011, fundamental valuations suggest that the Canadian bond market is fully valued. The economic recovery in this country is continuing, although it has become seemingly more dependent on the pace of U.S. growth than initially thought. U.S. growth, though, is accelerating from its summer doldrums, with tentative signs that the long-awaited improvement in the key labour market is finally occurring. As a result, Canadian economic growth should also improve, albeit with roughly a quarter lag behind the U.S. With the Canadian economy 18 months into recovery and looking likely to improve further, it seems odd that long term Canada bond yields remain near the their lowest levels of the past 50 years. We believe that, based on economic fundamentals, yields should rise somewhat through the coming year.

However, the current level of yields also reflects a high degree of investor uncertainty and caution. The ongoing European sovereign debt crisis has caused a flight to safety bid for alternatives to the Euro and European bonds. Canada has been a major beneficiary of investor demand, because of its relatively good fiscal situation, its open markets, and the strength of its financial sector. Foreign buying of Canadian bonds since the spring of 2010 has been at record levels and is a major factor behind yields being as low as they are. The risk for investors is that the level of foreign buying recedes to more historical norms, either as the sovereign debt crisis staggers closer to a long term resolution, or foreign investors identify more attractive opportunities elsewhere. Indeed, the Canadian bond market in recent months has performed markedly better than other major global bond markets and there is the potential for profit-taking by some of the recent foreign buyers.

Investor uncertainty and caution with regard to stock markets has also created a flight to safety bid for bonds. In the first half of 2010, equity market returns were negative and caused many investors to recall the severe bear market of 2008. Only a sustained bull market in equities is likely to alleviate investor concerns. Certainly the run up in equity markets since mid 2010 has been a start, and we believe that further gains are quite possible, given our positive economic outlook. Should equity markets produce double digit returns again in 2011, we believe that that will result in a shift away from bonds toward stock markets. This process, though, is likely to be a gradual one, taking place over several quarters.

Another area of concern is that the Bank of Canada is not yet finished raising interest rates. The Bank paused in October, following three consecutive increases, because of concerns that Canadian economic growth was slowing in reaction to weaker U.S. growth and a relatively strong Canadian exchange rate. Since that time, though the Bank has indicated that it is concerned that rates remain too low and are causing potentially harmful distortions in the Canadian economy. The recent increase in household debt to record levels is one example of those distortions. If we are correct that the Canadian economy will soon accelerate as U.S. demand picks up, the Bank of Canada may resume removing the extraordinary monetary stimulus before mid-2011. The bond market and investors will, of course, not wait for the Bank to actually move. Rather, they will anticipate the Bank’s actions, most likely by demanding higher yields on short and mid-term bonds.

In light of our concerns noted above, we have shifted the portfolio to a defensive structure. Duration, which reflects the fund’s sensitivity to yield changes has been reduced, and we are monitoring the market for opportunities for further reductions. Holdings of short and mid-term issues have been replaced with investments in money market securities and longer term bonds to minimize the impact of potential and anticipated rate increases by the Bank of Canada. Amongst the sectors, corporate bonds offer the best value with relatively wide yield spreads. Given the ongoing economic recovery, overall creditworthiness will continue to improve and may lead to additional gains for the sector. Government of Canada bonds, with their low yields, offer less income protection from possible price volatility and have been de-emphasized.

In the wake of the financial crisis, there have been ongoing efforts to strengthen the global banking industry. In particular, reforms to banks’ balance sheets are being developed to reduce the likelihood and cost of future government bailouts. The upcoming release of the Basel Committee’s recommendations on bank financing has the potential to cause significant long term changes to the instruments by which banks fund themselves. These recommendations will also have the potential to cause significant changes in the values of outstanding issues. In some cases, seemingly similar securities will be affected in dramatically different ways. We anticipate that much of our highly skilled and dedicated internal credit research this year will be directed at seeking out opportunities created by changes to bank financing regulations. This effort is likely to be complex and demanding, but may ultimately be quite rewarding for the portfolio.

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