Much of the foreign buying has been concentrated in the federal sector, because of Canada’s AAA rating. The available pool of AAA-rated securities has shrunk significantly in recent years, as several issuers have experienced downgrades due to deteriorating financial conditions. During the recent recession, for example, the massive U.S. mortgage lenders Fannie Mae and Freddie Mac lost their vaunted top ratings. Last year, the United States was downgraded by Standard & Poor’s and, this year, France was also lowered. In July, Moody’s announced that it was considering cutting Germany’s and the Netherlands’ AAA ratings because of potential fallout from the European sovereign debt crisis.

In addition to Canada bonds, Canada Housing Trust bonds, which are fully guaranteed by the Government of Canada, have experienced substantial foreign demand, because of their slightly higher yields. In the provincial sector, both Alberta and British Columbia have AAA ratings from most rating agencies, but only the latter has significant amounts of bonds outstanding. Foreign demand for B.C. issues is one reason they have outperformed most other provincial bonds this year. The yield spreads for Ontario and B.C. bonds are shown in the chart below. While the differential between B.C. and Canada bonds has increased slightly in 2012, the increment has been roughly half of that experienced by Ontario bonds. (An increase in the yield spread results in lower returns because relatively higher yields mean relatively lower bond prices.) As a result, B.C. bond returns have been better than Ontario returns by more than 1% so far this year. Foreign demand for the highly rated B.C. bonds has played a significant role in the better performance.

Provincial Yield Spreads

The Canadian yield curve flattened in July, as shorter term bond yields rose slightly, while longer term yields went down. Initially, yields of all maturities fell 10 to 15 basis points as negative investor sentiment prompted buying of bonds. However, ECB President Draghi’s comments late in the month caused a sharp selloff in bonds as riskier assets returned to favour. The selloff wiped out the earlier price gains for short term bonds and pared the gains of longer term issues. Yields of 2-year bonds climbed 5 basis points from month earlier levels and 30-year yields fell 6 basis points.

The federal sector returned 0.31% in the month. Lower prices for shorter term Canada bonds offset some of the gains experienced for longer term issues. Provincial bonds earned 0.96% in July. Provincial yield spreads narrowed by average 3 basis points. The longer average duration of provincial bonds and the narrower yield spreads contributed to the good returns. The provincial sector would have enjoyed even better results but for some weakness in Quebec bonds. Quebec bonds widened 3 to 5 basis points against other provincial issues, as the bond market reacted to speculation of a Quebec election in September. With the separatist Parti Quebecois leading the Liberals in the polls, the risk premium on Quebec bonds increased. The corporate sector earned 0.89% in the month. Notwithstanding the risk aversion that was evident for much of the period, Canadian investors were active buyers of corporate bonds in July. New corporate issues of approximately $4 billion failed to satisfy demand, and corporate yield spreads narrowed an average 9 basis points in the month.

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