The prospect that the Bank of Canada might take longer than previously expected to raise rates led to a decline in yields of short term bonds. The yield of 2-year Canada bonds, for example, declined 8 basis points. For longer maturities, though, yields moved higher, with the largest increases occurring with the longest term bonds. Yields of 30-year bonds rose 20 basis points in the month, resulting in a steeper yield curve. Interestingly, the shift in the Canadian yield curve was quite similar to changes in U.S. bond yields.

The difference between corporate bond yields and those of benchmark Canada bonds shrank by an average 6 basis points in January. As a result of the narrower yield spreads, the corporate sector had the best results of the month, returning +0.01%. In comparison, the federal sector declined 0.37%. Provincial bonds fell 1.05%, as their longer average duration resulted in larger price declines as yields rose. Provincial yield spreads narrowed by only 1 basis point as $4.3 billion of new issues satisfied investor demand.

Looking ahead, we believe that the flight to safety bid for bonds as a result of current geopolitical concerns will fade, and longer term fundamentals will become more important. In our view, economic growth in Canada and the United States has become self-sustaining and no longer dependent on government stimulus. Indeed, as governments struggle to reduce their fiscal deficits, the government sector will shift from boosting growth to subtracting from it. Improving economic conditions will be beneficial for equity markets and that is expected to cause an asset mix shift away from fixed income. Bond yields should move higher over the balance of the year, but the pace and magnitude of those increases will be limited by a number of factors. The value of the Canadian dollar in foreign exchange markets will impact economic growth through the export sector, and with commodity prices currently enjoying multi-year highs, the Loonie seems unlikely to fall in the near term, and may even appreciate further. Slower growth, as well as reluctance by the Bank of Canada to exacerbate the situation, will help hold Canadian bond yields from substantial increases. In addition, foreign investor demand for Canadian bonds has shown no signs of abating yet. Over the last year, net foreign buying of Canadian bonds has averaged over $8.5 billion per month and has been a significant factor in driving yields to current levels. Over the near term, there is little reason to expect a sharp change in foreign demand, although a gradual shift to other high yielding international markets may occur as economic confidence in those markets occurs. In short, we believe that yields will rise gradually rather than sharply.

In light of our expectations for a gradual rise in yields, we have taken a number of steps to structure the portfolio defensively. The duration of the portfolio has already been shortened, but we are looking for opportunities to reduce it further. Notwithstanding the steepening of the yield curve that occurred in January, we believe that short term yields are likely to rise more than longer term ones, Therefore, we have chosen to hold substantial amounts of money market securities in lieu of short term bonds that have the potential to decline in value as yields move higher. We have also emphasized the corporate sector of the market, because corporate bond yields are more attractive than those on government bonds and because there is the potential for gains as the spreads return to historical norms on improving economic and earnings fundamentals.

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