Investment dealer reports of substantial domestic interest in long-term interest rate swaps confirmed our suspicion that mismatched Canadian insurers and pension funds were being forced to add duration even as yields fell to record lows. With the sharp drop in yields that occurred in the second half of 2011, the present value of pension and lifeco liabilities would have increased substantially, and for those organizations that had not matched their assets very well, there would have been a large negative impact on their surpluses (or increases in their deficits). The use of swaps suggested some reluctance or inability to sell poorer performing assets such as equities or high yield bonds in favour of purchasing long-term investment grade bonds. However, the impact of the activity was the same, as the swap counterparties hedged their positions with bond purchases. The December bond rally was, to a certain extent, self-reinforcing, as lower yields placed even greater pressure on mismatched funds to add duration through either swaps or outright bond purchases, which in turn led to even lower yields. The approaching year-end reporting deadline undoubtedly added to the pressure to add asset duration in December.

We are defensive regarding the bond market for five reasons. First, current yields suggest investors are overly pessimistic about economic prospects. While the Eurozone may have fallen back into recession, almost every other industrialized economy is growing and unlikely to start shrinking for the foreseeable future. Indeed, China has stopped its monetary tightening and has begun easing that is expected to continue. In the United States, economic growth has accelerated as the labour market heals and the housing sector may start to rebound. However, Canadian and U.S. bond yields are actually lower now than during the depths of the severe recession in 2008. Barring an economic depression, which seems very unlikely, there isn’t economic justification for such low yields.

Long Term Canada Bond Yields

A third reason that we are defensive regarding bonds is their valuation relative to other asset classes. Simply put, stocks are extraordinarily cheap versus bonds. Corporations, by and large, are generating strong and growing profits, and have plenty of cash on their balance sheets with which to finance their businesses. Dividend yields are competitive versus the yields available on the same issuers’ bonds. In addition, earnings multiples are quite low, given the extraordinarily low yields of the bond market. While we appreciate the volatility of the stock markets, including losses in two of the last four years, has discouraged investor participation, we believe that, if we are correct about economic growth continuing in North America and globally, there is the likelihood of a strong equity rally that will pull investment funds away from the safety of fixed income investments.Second, concerns about a possible credit crisis arising from the European sovereign debt crisis have caused a flight-to-safety bid for U.S. and Canadian bonds that appears excessive. While a credit crisis, of course, would pose great challenges, it is far from certain that one will actually occur. The European Central Bank is fulfilling its role as the lender of last resort to European banks and providing ample liquidity to prevent the financial system from seizing up. In addition, global monetary authorities well appreciate the dangers of another credit crisis and are actively taking steps to prevent it. Also, global banks are in better financial condition than three years ago, making them more resilient should a crisis develop. So it doesn’t seem appropriate that government bond yields should be below the levels reached in the post Lehman Brothers crisis.

Another factor that leads us to be cautious is that Canadian monetary policy is excessively stimulative based on current Canadian economic conditions. The Bank of Canada aggressively cut interest rates in the crisis of 2007-2009 from 4.25% to 0.25%. Since then, the economy has recovered but the Bank has raised rates back to only 1.00%. Average household debt levels are dangerously high and house prices, at least in some Canadian cities, seem to be approaching bubble status. Rather than encouraging restraint on the part of consumers, the Bank’s decision to keep rates low is providing an incentive to borrow more. In the short term, the Bank of Canada is focussing on potential risks of a global economic slowdown hurting the Canadian economy, but if that slowdown fails to materialize or is less severe than feared the Bank should start paying more attention to the domestic need for higher interest rates. Any hint that the Bank was likely to raise rates would result in a sharp selloff in bonds across the yield curve.

A final reason that we are defensive regarding bonds is that inflation remains too high. The decline in yields associated with the bond market rally this year, combined with stubbornly high inflation, means that yields of government bonds are failing to compensate investors for rising prices. Real yields (i.e. the nominal yield less inflation) are negative in Canada, the United States, and much of Europe. While this can continue for some time, history suggests that investors will eventually demand to be compensated for inflation through higher yields. The initiative to higher yields may come from investors, or it may come from central bankers. In its October Monetary Policy Report, the Bank of Canada indicated that it expected Canadian inflation to fall from the current 3% to only 1% by mid-2012, because the Bank predicted slower global growth would result in falling energy prices. Since then, however, U.S. growth has accelerated and energy prices have actually risen, not fallen. As a result, the Bank is under increasing pressure to raise rates.

In light of what we believe are significant downside risks for bonds, we have taken a number of steps to structure the portfolio to protect capital. Duration has been reduced to approximately 1½ years less than the benchmark, making the portfolio less vulnerable to rising yields. Indeed, should we observe a reduction in buying by mismatched pension funds and lifecos, we will look to further reduce duration. Money market holdings, at roughly 25% of the portfolio, will help insulate the fund from rate increases and a flattening yield curve. The sector allocation has minimized low-yielding federal bonds and over-weighted high yielding corporate issues. However, a significant portion of the corporate holdings are either quite short (i.e. under 3 years to maturity) or are floating rate notes. These positions will be switched into longer term issues as it becomes more certain that a credit crisis has been averted. Within individual security selection, we have reviewed every corporate issue and are comfortable that, in the unlikely event of a credit crisis, each holding should remain creditworthy. We have avoided any direct European exposure and indirect exposure through issuers’ business activities appears low. Holdings of U.S. financial issuers, because of their potential global interconnections, have also been curtailed.

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