The Canadian yield curve steepened very modestly in March as 2-year Canada Bond yields rose 3 basis points while 30-year yields increased 7 basis points. The relatively small net changes did not reflect the volatility experienced in the month; 30-year yields for example fluctuated in a wide 30 basis point range during the period. In large part, the volatility of Canadian bonds was a reflection of events in the U.S. bond market, where 30-year Treasury yields moved in a similar 28 basis point range. However, in contrast with Canadian yields, U.S. bond yields closed the month slightly lower.

Federal bonds returned -0.34% in the month, as the higher yields caused prices to decline somewhat. Provincial bonds declined -0.45%, as their longer average durations more than offset the positive effect of slightly tighter yield spreads. The corporate sector was the best performing one in the period, returning -0.12%, as strong investor demand caused yield spreads to tighten modestly. The corporate sector performance was all the more impressive in light of very substantial new issuance. New issues totalled $14.4 billion in the month, bringing the first quarter total 35% above year ago levels. Noteworthy among the new issues were a $2.2 billion dual tranche Royal Bank covered bond, a $1.75 billion three part Telus financing, and the Bank of Nova Scotia’s first NVCC subordinated debt issue that raised $1.25 billion. High yield bonds returned -0.12%, in line with investment grade issues. Real Return Bonds declined -2.26%, as energy prices subsided somewhat in the month and investors were less interested in inflation protection.

We believe Canadian economic growth in the first quarter will have been barely positive when the data becomes available. But it should improve over the balance of the year, partly as a result of the depreciation in the exchange rate over the last year, and partly due to re-acceleration in the U.S. economy. The temporary headwinds for the U.S. that included severe winter weather and the West Coast port strike are behind us and the economy should accelerate back to +3.0% pace. In addition, the U.S. dollar has stopped appreciating and that should allow the U.S. export sector to rebound somewhat. As well, there are tentative signs of improving growth in both Europe and Asia. As a result, we believe that investors will begin to anticipate less stimulative monetary policies and eventual interest rate increases.

We anticipate that bond market volatility will remain elevated in the near term. Quantitative easing by various central banks, including those of the United States, Britain, and Japan, as well as the ECB has substantially reduced the availability of government bonds leading to ultra-low yields. At the same time, regulatory changes and zero interest rate monetary policies have also encouraged commercial banks to hold high quality government bonds. While economic conditions do not justify current yield levels, the elevated volatility makes us reluctant to reduce portfolio durations significantly at this time. We also note some potential near term shocks that include the election in Great Britain that could result in a very different looking coalition and the debt renegotiations with Greece that could lead to it defaulting on loans to the International Monetary Fund and the ECB. Either event could cause market uncertainty.

The yield curve is quite flat for securities maturing out to 4 years, so we are shifting out of 2017 to 2019 maturities to pick up yield in longer term issues. At this time, the best risk/return trade-off appears to be in 15-year bonds. In terms of sectors, the very low yields on Canada Bonds make them relatively unattractive. In some cases, the yield spreads on corporate issues are greater than the underlying Canada Bond yield. That suggests there may be some downward pressure on yield spreads as investors scour the markets for better returns.

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