The Bank of Canada’s musing about negative interest rates was the catalyst to push Canadian bond prices higher. Yields of Canada Bonds across all maturities fell between 14 and 18 basis points, as the yield curve executed a nearly perfect parallel shift lower. In contrast, U.S. bond yields moved slightly higher in the month, reflecting the Fed’s shift toward higher rates. Interestingly, though, most of the rise in U.S. bond yields occurred before the Fed announcement rather than after it.

The decline in yields propelled the federal sector to earn 1.05% in the month. Notwithstanding marginally wider yield spreads, the provincial sector gained 1.66% in the period because its longer average duration resulted in larger price gains as yields declined. The weaker economic outlook hurt the investment grade corporate sector, which returned only 0.60%. The yield spreads of corporate issues widened 8 basis points on average as investors demanded greater risk premiums. New issue supply was relatively light at less than $4 billion. High yield corporate bonds dropped -2.28% in the month, with the energy-related issues plunging 6.39% as oil prices fell. Real Return Bonds earned 1.58%, as their long average durations resulted in good price gains. Preferred shares shrugged off tax-loss selling early in the month and returned +2.30%.

Looking forward, we believe that central banks will continue to be a source of significant volatility in the bond market. The Bank of Canada has already shown its willingness to cut interest rates in a mostly futile effort to offset the impact of falling oil prices. In doing so, the Bank has ignored the potential long term risks of further inflating what may be a housing bubble and encouraging over-leveraged households to add even more debt. The interest rates reductions in January and July contributed to a substantial drop in the Canadian exchange rate during 2015, but the hoped for pickup in exports has yet to materialize. Given the lack of growth in the Canadian economy, we believe there is a risk that the Bank will choose to reduce interest rates again in the coming months. To mitigate the potential impact of this, we have increased the holdings of short term bonds and reduced cash equivalents. We have also kept durations close to benchmark levels in light of the volatility.

We believe the Fed will follow up its December interest rate increase with additional hikes in 2016. However, if U.S. GDP growth remains at or below 2%, the Fed will likely move only 2 or 3 times, rather than the consensus outlook for 4 increases this year. As the market anticipation of Fed rate increases builds we think that will put upward pressure on U.S. bond yields. That should in turn lead to higher yields for longer term Canadian bonds. We note that, from an historical perspective, Canadian bond yields are very unattractive versus those of U.S. bonds. Over the last 65 years, U.S. Treasury Bond yields have usually been below those of Canada Bonds, but currently offer a record pickup.

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One of the factors driving Canadian yields so far below U.S. yields appears to be offshore investor purchases of Canadian bonds. While U.S. investor interest in Canadian bonds was relatively stable in the last two years, non-U.S. foreign buying has increased markedly. With the anticipation and implementation of massive quantitative easing programmes by the European and Japanese central banks, yields in many global bond markets plummeted along with the supply of available bonds. In some cases, government bond yields have actually gone negative. By comparison, Canadian yields looked attractive, and that prompted buying. Until the ECB scales back its quantitative easing and allows European bond yields to move to more normal levels, foreign purchases may remain elevated and hold Canadian yields lower than would otherwise occur.

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Corporate yield spreads widened significantly in 2015. In some cases, such as for oil & gas issuers or companies implementing credit-negative changes to their capital structure, the spread widening appeared justified. But overall, the widening seems to be discounting a serious recession, which we don’t believe will occur. We, therefore, view the corporate sector as very attractive and are looking to add to the sector allocation once spreads have stabilized.

We also continue to be concerned about inflation. While energy prices have depressed CPI in the short term, the plunge in the value of the Canadian dollar is likely to more than offset lower oil prices. Rising costs for imports, including food, are likely to push Canadian inflation higher and, consequently, we are maintaining our holdings of Real Return Bonds.

 

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