Bond prices declined and yields moved higher in February as investors became more confident about growth and less concerned about the European sovereign debt crisis. Riskier assets, such as equities and the Euro, enjoyed rallies while safer investments such as Canadian and U.S. government bonds fell in value. The DEX Universe Bond index fell 0.40% in the month.

Economic data in Canada was mixed during February. Housing starts remained firm and leading economic indicators pointed to continued economic growth in coming months. Less positively, retail sales growth was tepid and the Canadian economy struggled to create new jobs. As a result, the unemployment rate rose to 7.6% from 7.5% the previous month. Inflation rebounded to 2.5% from 2.3%, in part due to rising gasoline prices.

In the United States, the economic news was more positive. In particular, the labour market continued to recover from the recession as initial claims for unemployment benefits fell to the lowest level in four years and unemployment fell to 8.3% from 8.5% the previous month. Job creation was robust, with 243,000 net new jobs created. Among businesses, the manufacturing and service sectors experienced strength. Even the housing sector improved somewhat with housing starts and new home sales higher than expected. However, average home prices continued to decline under the pressure of the overhang of foreclosed homes.

Also positive was the progress made to resolve the sovereign debt crisis in Europe. Following the imposition of more stringent spending cuts on Greece, Eurozone countries agreed to provide additional bailout funds to that country. As well, the implementation of debt restructuring on privately held Greek debt overcame several critical hurdles, including passage of legislation to force all holders to accept any majority vote to restructure the bonds with lower coupon rates and longer maturity dates.

Yields of benchmark Canada bonds rose roughly 10 basis points for all terms to maturity during February. Shorter term yields rose slightly more than longer term ones, as bank selling caused their yields to rise more. The recent reduction in the 5-year mortgage rate to 2.99% apparently resulted in significantly increased demand for fixed rate loans. To hedge this increased demand, the banks sold 5-year Canada bonds in significant quantity, pushing their price down and yield up. We expect the underperformance of 5-year bonds will end shortly as the special 2.99% mortgage rate has been terminated at the major banks, mortgage demand slows and the banks unwind their hedges by buying back 5-year bonds.

Among the Canadian bond market sectors, corporate issues had the strongest performance in the month, earning +0.29%. Notwithstanding very good new issue supply, robust investor demand for corporate bonds led to yield spreads narrowing by an average of 10 basis points. So far in 2012, new corporate issues have totalled a record $18.5 billion and yet spreads have compressed by an average 21 basis points as investors have become less risk averse. Federal issues declined 0.49% in February because of rising yields. Provincial issues trailed other sectors, falling 0.88%, with average yield spreads widening 4 basis points. The widening of provincial yield spreads was due, in part, to concerns that Ontario may be downgraded and the release of the Drummond Report that highlighted the urgent need to reduce public spending in that province.

Since mid-December, Canadian bonds have been range bound. The yield of 10-year Canada bonds, for example, has fluctuated between 1.90% and 2.10% for the last two and a half months. This follows the pattern of the U.S. bond market, which has been in a holding pattern for the last four months. However, while bonds may continue to move sideways in the near term, we believe that they will ultimately move to higher yields and lower prices for a number of reasons. One reason is that we expect the flight to safety bid for bonds that developed last year will reverse as equity markets show positive returns and the European sovereign debt crisis progresses toward eventual resolution. A second reason for yields to rise is that economic growth in the United States will surprise to the upside, with good job creation leading to lower unemployment and improved consumer spending. Stronger economic growth will support equity markets and also raise the prospect of eventual interest rate hikes by the Federal Reserve. Another reason for higher yields is that rising energy prices are likely to push inflation back toward the 3% level. The diminution of the risks of a credit crisis developing and spreading from Europe mean that the Bank of Canada is increasingly likely to pay attention to the domestic need to raise rates and slow inflationary pressures.

In light of our expectation that yields will move higher in the coming months, we are maintaining a defensive structure to the portfolio. Duration is significantly shorter than the benchmark, to reduce the impact of higher yields. In addition, substantial money market positions are being held instead of short and medium term bonds because we believe those terms will face the greatest jump in yields. We are also retaining the Real Return Bond position as a hedge against higher than desired inflation. Sector allocation continues to favour corporate bonds versus government issues, because yield spreads are historically attractive and the economic environment remains positive.