The Canadian yield curve steepened modestly in June. Despite the Bank of Canada’s warning about potential rate increases, yields of benchmark 2-year Canada bonds fell 3 basis points as investors sought low risk vehicles to ensure return of capital (as opposed to return on capital). In contrast, 30-year Canada bond yields rose 4 basis points in the month, suggesting investor reluctance to lock in record low yields for long periods. Yields on 5 and 10-year bonds were unchanged.

Federal bonds earned an average 0.04% in June. Price declines of 30-year bonds due to the higher yields offset much of the income received on the spectrum of Canada bonds. Provincial bond returns averaged -0.08% in June. Provincial yield spreads widened an average 2 basis points and their longer average durations also detracted from performance as long term yields rose. Corporate bonds returned 0.04% in the month. Yield spreads widened an average of 5 basis points, because of specific ratings actions as well as more generalized concerns about creditworthiness as economic growth slowed. Noteworthy among specific ratings actions was Moody’s decision to downgrade Royal Bank of Canada along with 16 other global banks, because of its capital markets exposure. While the downgrade brought Moody’s ratings more in line with those of other agencies, it did put some pressure on Royal Bank’s yield spreads as well as those of other Canadian banks. Also pressuring corporate spreads were concerns about overall creditworthiness. Global corporate bond defaults have nearly doubled so far this year compared with the same period in 2011, according to Standard & Poor’s, with the majority of defaults occurring in the United States. After a strong start to the year, companies with lower credit ratings saw debt capital markets dry up in the second quarter as worries over the fate of the European debt crisis and weaker economic growth reduced investor appetite.

While we believe that bond yields are unattractive from an historical perspective, they may remain low for several more months. Economic uncertainty is high, with Europe in recession and the United States decelerating. The European conundrum is to promote growth and fiscal austerity simultaneously, but there is, as yet, no credible plan for achieving both objectives. In the United States, growth has already slowed with very substantial fiscal tightening possible in 2013. Barring an unlikely political compromise, a substantial number of tax cuts and spending programmes expire in 2013, which will act as a significant drag on the economy. By some estimates, the impact will be the equivalent of a 5% reduction in U.S. GDP, resulting in the economy falling off a “fiscal cliff”. Unfortunately, with this being a presidential election year combined with the current poisonous, polarized state of U.S. politics, alleviating some or all of the looming fiscal drag is unlikely. Consumer and business confidence is already beginning to decline, because the fiscal cliff would lead the U.S. economy back into recession.

Weaker growth in Canada’s trading partners would negatively impact our economy. Domestic demand held up reasonably well in the recent financial crisis, so there appears to be little pent-up demand to support Canadian growth. As well, sharply lower energy prices threaten capital spending projects that have been sources of strength to date.

The European sovereign debt crisis, weaker global banks, and the collapse of U.S. housing agencies Fannie Mae and Freddie Mac has substantially reduced the supply of “safe” assets. Canadian government bonds, particularly AAA-rated federal issues, are in demand because they are perceived to carry less risk than most alternatives. In the current economic environment, that demand seems unlikely to slacken in the near term. Accordingly, we are keeping portfolio durations close to benchmark values.

The short term portion of the yield curve is quite flat and expensive. For example, the yield of benchmark 5-year Canada bonds is currently 1.25%, or only 25 basis points above the Bank of Canada’s overnight interest rate target. Unless the Bank of Canada cuts rates in the near future, which we think unlikely, yields of 3 to 5-year bonds are unattractive because they fail to compensate investors for the additional risk they carry. Accordingly, we have de-emphasized those terms, preferring to hold bonds with 2 years or less to maturity or money market securities.

Corporate bond yield spreads are attractive from a historical perspective, but may widen further should economic growth falter. Weightings of corporate bonds in the portfolio are above average, but not at policy limits. Should spreads widen and become even more attractive, we will have capacity to add at very attractive levels. We continue to avoid issuers with substantial exposure to Europe, and have limited direct exposure to U.S. issuers. We have also reviewed individual holdings to reduce the potential impact of an economic downturn. In addition, Real Return Bond holdings have been reduced, because we see less inflationary pressure in the near term.

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