Yields of benchmark Canada bonds of all maturities rose in March, with the largest increases occurring in mid-term issues. Yields of 5-year and 10-year bonds were higher by 13 basis points, as selling by banks to hedge larger than expected mortgage demand put downward pressure on bond prices and upward pressure on yields. As well, investors responded to the Bank of Canada’s more hawkish statement and adjusted their expectations for future rate increases. In the United States, the greatest yield increases occurred at the longest maturities, as investors reacted to the ongoing positive economic data. Yields of 30-year Treasuries increased 26 basis points in the month, while those of 2-year Treasuries were little changed. The shifts left the yield curves in Canada and the United States markedly different at the end of the month. Relative to the U.S., short term yields in Canada are higher, while longer term yields are lower. The difference in short term yields is due primarily to monetary policy and different overnight interest rate targets (i.e. 1.00% in Canada and 0.25% in the United States). Canadian bond yields remain near all-time historical lows as investors seek the perceived safety of this country’s better fiscal management and stronger banking sector. Even though the Fed’s Operation Twist has artificially lowered long term bond yields, the seemingly intractable U.S. fiscal situation mean that the U.S. Treasury will need to issue very large quantities of bond for the next several years. In addition, the lack of a credible plan to restore the U.S. budget to balance has created a risk premium as investors demand higher returns.

Canadian & US Yield Curves

The increase in the yields of Canada bonds during March resulted in lower prices and the federal sector consequently declined 0.40%. Corporate bonds fared better, returning +0.12% in the period. The continued improvement in the economic environment, combined with reduced new issue supply, led investors to bid up existing corporate issues, leading to an average 11 basis point narrowing of yield spreads. In contrast, the provincial sector had little change in spreads during the month. With longer average durations, provincial bonds experienced larger price declines, resulting in -0.59% average returns. Among the provinces, Ontario was a laggard due to concerns of a possible rating downgrade. The subsequent Ontario budget partially addressed the province’s fiscal problems, but it is unclear that a downgrade will ultimately be avoided. By comparison, British Columbia bonds narrowed 2 to 4 basis points versus comparable Ontario issues, because of a better budget situation and lower supply pressures.

During the first quarter of 2012, the Canadian bond market experienced a partial reversal of a number of the trends that were significant influences in 2011. Among those were the risk aversion stemming from the European sovereign debt crisis and concerns about U.S. economic growth, as well as falling equity values. Foreign investors became less interested in Canada as a safe haven, and domestic investors started to demand higher yields to stay in bonds. Higher risk tolerance also resulted in corporate yield spreads narrowing significantly in the quarter, thereby reversing part of the widening that occurred last year.

We believe the reversal of last year’s flight-to-safety bid for bonds will continue. The European Central Bank’s provision of 1 trillion euros of term financing to European banks substantially reduced the risk of a credit crisis. Greece has defaulted in an orderly fashion, without causing a financial panic. U.S. growth has surprised to the upside, and not simply because of a warmer than usual winter. Job growth accelerated last fall and is resulting in better consumption. As well, the U.S. housing sector is showing tentative signs of improvement as prices stabilize and starts edge higher. While there remains a significant overhang of foreclosed homes, we believe that pent-up demand from the last five years will offset it. Should the housing sector indeed start to recover, that bodes well for the labour market and unemployment, because two million construction jobs were lost in the housing collapse.

Canadian economic growth, we believe, will be tepid for the balance of this year. However, stronger growth from the United States should benefit the Canadian export sector. Economic growth, though, may take a back seat to market sentiment in determining the direction of the bond market in 2012. Risk aversion pushed bonds to extreme valuations in 2011 and unwinding that move should lead to higher yields even if growth slows further. As long as North American economies avoid recession, we believe the path is toward higher yields. Accordingly, we are keeping portfolios defensively structured with shorter durations and relatively high cash positions. Corporate bonds still offer historically attractive yield spreads, so that sector is over-weighted versus government bonds.

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