The Canadian yield curve flattened in June, as investors sought the safe haven of bonds in the uncertainty caused by the Brexit vote. The decline in shorter term bond yields appeared limited by the 0.50% Bank of Canada overnight target rate, while longer term yields had greater potential to move lower. Yields of benchmark 2-year Canada Bonds fell 9 basis points (to 0.52%), while yields of 10 and 30-year Canada Bonds each dropped roughly 25 basis points in the month. The flight to safety bid for bonds was even more apparent in the U.S. bond market as 2-year Treasury yields declined 27 basis points while longer term Treasury yields fell 33 to 35 basis points. The move downward in U.S. yields also reflected a change in the consensus to expectations of fewer and slower Federal Reserve rate increases in the coming quarters.

The decline in yields produced higher bond prices in June, and the federal sector returned 1.44%. The provincial sector, which has a higher average duration and thus responds more to yield changes, returned 2.51% in the period. Investment grade corporate bonds lagged government issues, returning 1.26% in the month. Corporate yield spreads widened a few basis points in the risk-off sentiment following the British referendum. High yield issues returned 1.51%, led by a continued rebound in energy issues. Real Return Bonds earned 1.87% on average in June. Preferred shares declined -0.63%, with older, low spread rate reset issues particularly weak.

In June, the provider of the FTSE TMX Canada Bond indices announced a change regarding ratings. Effective in September, PCBond will start using ratings from Fitch in addition to those of DBRS, Standard & Poors, and Moody’s. For split ratings (i.e. if the rating agencies don’t agree) when two agencies rate the bond, the lower rating will apply. For three ratings, the most common rating will apply. If all four agencies disagree, the lowest three ratings will be used using the three rating rule. The change will affect only a handful of issuers with some being upgraded to the A category and others moving lower to the BBB category.

We believe the volatility and uncertainty due to Brexit may last for a few months. Firstly, the British Conservative party must select a new leader as the current Prime Minister, David Cameron, has resigned and will not deal with the European Union departure. The leadership contest is expected to last a couple of months. Secondly, once a new Prime Minister is in power, it is not clear whether Parliament will have to approve the decision to trigger Article 50 which governs the exit process. As the referendum was, in fact, non-binding, Parliament might choose to not approve a departure from the E.U. The likelihood of rejecting the referendum results will rise if the economic consequences appear too dire, if the British pound plummets too far, or if Scotland appears likely to hold a second referendum to secede from the United Kingdom. A third consideration is that the “Exit” side never presented a cohesive strategy for how to deal with the various dislocations that would result from leaving the E.U. Greater focus on trying to develop such a strategy may lead to caution about actually initiating the departure.

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, it is possible that these factors will push yields even lower. 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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