Somewhat lower yields resulted in modest price gains for most Canada bonds, as the federal sector earned 0.47% in the month. On average, provincial yield spreads were unchanged and that sector benefitted from its longer average duration as yields moved lower, returning 0.93%. Corporate yield spreads widened an average 5 basis points in December, thereby reducing the sector’s returns to only 0.26%. The energy sector was especially hard hit, not only because of weak oil prices but also an ill-received corporate reorganization by Enbridge Inc. That company announced plans to drop $17 billion of assets down into its Enbridge Income Fund subsidiary, in a move that weakened the creditworthiness of the parent company’s bonds and led to downgrade warnings from various rating agencies. Enbridge bonds widened as much as 50 basis points to benchmark Canada bonds as investors re-evaluated the company’s riskiness. The Enbridge move was, to say the least, puzzling because the company is in the midst of a massive capital spending programme that requires a substantial amount of debt financing. In 2014 alone, the Enbridge group of companies was the single largest corporate borrower in Canada outside of the banks, raising $3.7 billion. High yield bond issues returned -2.98% in the month, dragged lower by an average -7.61% return for high yield energy issuers. Real Return Bonds fell 0.78%, as lower inflation reduced demand.

We believe the plunge in oil prices reflects geopolitical decisions rather than falling demand due to weak global economic activity. While demand is clearly insufficient for current levels of production, the willingness of traditional swing producing nations to let prices keep falling suggests that this is not about economic concerns. Rather, we believe that the Saudis are trying to weaken both Iran and Russia, and to do that will require oil prices to stay very low for a year or more.

Very low oil prices will lead to reduced activity in Canada’s energy sector. Employment losses and cutbacks in investment spending appear likely. On balance, that should lead to a reduction in Canadian GDP growth of approximately 0.5%, which would leave growth in the vicinity of 2.0%. We do not believe at this time that Canada is headed for a recession, because other sectors of the economy actually should do better in the current environment. The decline in the exchange rate will benefit exporters, and consumers will have more money to spend as a result of lower energy expenses. The Bank of Canada will not quickly follow any U.S. Federal Reserve rate increases. Instead, the Bank will probably leave Canadian interest rates unchanged this year to offset the slowing of the energy sector.

The U.S. economy appears to be powering ahead and lower oil prices will only serve to add stimulus to it. The Fed is expected to begin moving interest rates higher in the first half of 2015, because there is no longer any reason for keeping rates close to zero. While inflation may be temporarily depressed as a result of lower energy prices, the Fed’s other mandate, to maximize employment, is close to fulfilment. With unemployment under 6%, strong job creation and an increasing number of job openings, the Fed cannot justify current interest rate levels.

As the Fed’s first rate increases approaches, investors will likely re-evaluate current bond yields. We believe that, faced with what is likely to be a slow steady series of rate increases in money market yields to approximately 1.50% to 2.00%, they will not be satisfied with 5 and 10-year Treasury yields that are currently close to those levels. That should result in the long delayed retrenchment in bonds. What remains to be seen is whether yield-starved investors from around the globe will ignore the Fed’s moves and continue to buy U.S. (and Canadian) bonds because they yield substantially more than the alternatives in Europe and Japan. The massive monetary stimulus in each of those locales is in effect causing significant inflation in the values of financial assets in a desperate attempt to achieve faster economic growth. But after six years of extraordinary monetary stimulus, growth remains disappointingly weak and it appears that something else is required. That something else may take the form of increased government spending (fiscal stimulus), relaxed labour laws (to encourage hiring), or increased immigration. However, until measures such as those are adopted, monetary policy in many parts of the world will remain very stimulative. In light of the impending move by the Fed we are keeping durations somewhat shorter than the benchmarks. However, we recognize the potential for the current bond market rally to continue in the near term so we are not making further reductions to durations at this time.

The corporate sector remains our preferred one at this time. Creditworthiness, outside of the energy sector, remains favourable and the recent widening of yield spreads may be a buying opportunity. Provincial yield spreads, with the exception of Alberta and Saskatchewan, have been in a relatively narrow range for several months and we do not anticipate that changing. We anticipate remaining underweight the provincial sector, but only because we do not see value in shorter provincial issues. Real Return Bonds, which have lagged nominal bonds as gasoline prices have fallen, have become relatively cheap and we will look to add to the holdings should they cheapen further. We remain very selective regarding high yield issues due to the lack of liquidity and resultant volatility of these bonds.

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