The Canadian yield curve flattened somewhat in July as short term bond yields edged slightly higher while longer term yields moved lower. The shift in the Canadian yield curve closely tracked the move in the U.S. yield curve. With the Bank of Canada and the Fed standing pat on interest rates, there was little room for shorter term yields to improve versus the respective overnight target interest rates. However, investors still searched for yield, and apparently ignored duration risk as they purchased higher yielding long term bonds.

The federal sector earned 0.37% in the month, with long term issues providing most of the gains. Provincial bonds returned 1.39%, as they benefitted from longer average durations as well as a 6 basis point narrowing of yield spreads. It appeared that provincial bonds were in demand from yield-starved foreign investors as well as domestic accounts. Investment grade corporate bonds earned 0.74% in July. Corporate yield spreads narrowed an average of 5 basis points, which was remarkable in light of $19.4 billion of new fixed rate issues in the month. Not only was that the heaviest monthly total so far in 2016, it was a record for any July, a traditionally slow month for issuance. In addition, there were $4.6 billion of floating rate notes issued in July. Having focussed their financing in the U.S. and the Euro market in the first half of the year, Canadian banks were the main issuers in the domestic market in July. Toronto Dominion Bank alone raised $6 billion in the month, spread between covered bonds, deposit notes and FRN’s. High yield corporate bonds gained 2.48% in the period. Energy issues had the highest returns, which was a little surprising given the drop in oil prices. Real Return Bonds earned only 0.64%, thereby lagging long term nominal issues as inflation remained dormant. Preferred shares surged 3.61% in July; in contrast with corporate bonds, there was a shortage of new preferred issues and ongoing demand pushed share prices higher.

As we noted last month, economic growth in Canada, the United States, and globally is expected to be positive in the second half of the year. However, bond markets are not currently focussed on economic conditions. Instead, political developments and continued quantitative easing programmes by some central banks are dominating bond markets. Notwithstanding that many bond yields are at all-time record lows, including US$12 trillion of bonds trading at negative yields, it is possible that these factors will push yields even lower. At least, we anticipate continued volatility. Accordingly, we think it is prudent to keep portfolio durations close to their respective benchmarks.

While the Bank of Canada is unlikely to raise interest rates for the foreseeable future, it is also unlikely to cut rates. As a result, with 5-year Canada yields very close to 1-year yields, we are minimizing holdings of 2 to 5-year bonds. Instead, we are holding a combination of longer term issues and cash equivalents. Corporate yield spreads are at historically attractive levels, so we are over-weighted in that sector. However, we are being cautious about issuers that may be negatively affected by ultra-low yields, such as large pension fund sponsors and life insurance companies. We are also cautious regarding the competitive state of retailing in Canada.

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