The Canadian yield curve flattened slightly in March. Yields of 2-year bonds rose 2 basis points, primarily in reaction to the monthly jump in inflation. However, yields of 5 and 30-year bonds moved slightly lower in response to 10-year bond yields falling 8 basis points. The good performance of 10-year issues was probably due in part to foreign buying of Canadian bonds through the futures market. Federal bonds returned, on average, 0.32%, as the slight decline in yields produced small price gains in addition to interest earned. Provincial bonds gained 0.42%, as their longer average durations offset the impact of wider yield spreads. Provincial spreads increased slightly on concerns of new issue supply pressure. Following a quiet month for new issues in February, corporate new issuance was robust in March. A total of $10.3 billion of fixed rate bonds and $3 billion of floating rate notes came to market in the month, with banks and telecom companies raising the largest portions.

Looking ahead, we are slightly optimistic about the prospects for Canadian economic growth for two reasons. First, the American economy is showing surprising strength and that bodes well for Canada’s export sector. Second, the Canadian energy sector has recovered somewhat from the weakness experienced late last year.  In the last three months of 2012, the price of oil produced in Western Canada fell sharply as pipeline constraints forced producers to accept steep reductions in their netbacks. The differential between the North American standard for oil prices, West Texas Intermediate, and Western Canadian Select widened from about $10 to almost $40 per barrel. Western Canadian Oil Price Differential The sharply lower price for Canadian oil reduced producer profits and led to more cautious capital spending in the energy sector. In addition, government royalties for both provincial governments and the federal government declined, leading to larger deficits. This year, however, the price for Canadian crude has recovered which should help bolster both private sector spending and public sector budgetary balances.

The improvement in Canada’s economic prospects are unlikely, though, to spur the Bank of Canada to change interest rates this year. As a result, yields of very short term bonds are not expected to increase significantly. Longer term bond yields, however, are anticipated to move somewhat higher as the global economic recovery strengthens. The timing and magnitude of that move will depend on whether there are any more flare-ups in the European debt crisis as well as the level of foreign demand for Canadian bonds. In anticipation of somewhat higher yields, we have shifted the duration of portfolios to be more defensive. We will look to further reduce duration should the tactical opportunity arise.

Corporate bonds remain our preferred sector, but their spreads are no longer compelling. Accordingly, we will look to realize profits in situations where there is little prospect of further spread tightening. We remain cautious about issuers over-exposed to the housing market and we continue to avoid European issuers.

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