Canadian bond yields rose modestly in the first two weeks of the month and declined over the balance of the period to finish with little net change. Yields of 2-year bonds, for example, were 1 basis point higher at the end of the month versus the beginning, while yields of 30-year bonds edged 3 basis points lower. In the United States, mid and long term bond yields finished 5 basis points higher as the impact of the widely-expected Fed rate increase was mostly offset by lower expectations of U.S. economic growth due to failing optimism in the new administration’s abilities.

Federal bonds earned 0.20% in the month. Provincial bonds gained 0.61%, on average, reflecting the fact that most of the sector are long term bonds, which had slight declines in yields, and a slightly narrower yield spread versus benchmark Canada bonds. Investment grade corporate bonds earned 0.41%, with their yield spreads marginally tighter on average. Corporate fixed rate issuance was relatively high at $9.7 billion, while floating rate new issues added a further $1.5 billion. Non-investment grade corporates earned only 0.06%, following several strong months’ performance. Real Return Bonds returned -0.19%, as the drop in oil prices below $50 per barrel for the first time in four months reduced inflation concerns. Preferred shares were the top-performing fixed income class in March, gaining 1.81%.

On April 12th, the Bank of Canada will release its quarterly Monetary Policy Report and announce its next decision regarding interest rates. We believe that the Bank is unlikely to change rates at that time, but it will be very interesting to learn how the Bank reacts to the recent string of stronger than expected economic data. While one economic sector on which the Bank has been focussing, non-energy exports, has remained disappointingly weak, the balance of the economy has been performing much better than the Bank had anticipated. The amount of economic slack in the Canadian economy, known as the output gap, will have been substantially reduced in the last three quarters. With the Canadian inflation rate already at the Bank’s 2% target, the Bank will be hard pressed to stay as dovish as it has been on the direction of interest rate for the next few quarters.

Should the Bank acknowledge the improvement in the Canadian economy, it may adjust its forecast for the closing of the output gap (i.e. when the economy will return to full employment). That, in turn, will have implications for the timing of the Bank to begin raising interest rates. Any indication that the Bank is more likely to raise rates in the next year will lead to a reaction in the bond market. Shorter term bond yields, in particular, will probably adjust upward. However, if the Bank does not give any indication that it is changing its outlook yet, the bond market may on its own start to discount future monetary tightening if the economic data remains strong. Accordingly, we are considering adjusting the yield curve positioning of the portfolios to reduce the exposure to short and mid term maturities.

The recent market movements have left bond prices near the higher boundary of the trading range that has been established since early December. With no apparent catalyst to cause the trading range to be breached, we believe it will continue, at least in the short term. If we are correct regarding the trading range, bond prices are more likely to decline somewhat and, therefore, we are taking steps to reduce portfolio durations somewhat.

Corporate bonds continue to offer attractive yields, but their long rally versus benchmark Canada bonds has left them fairly valued, rather than cheap. Yield spreads may compress further, but the low hanging fruit has already been picked. Selectivity is increasingly important within the corporate sector. Preferred shares remain useful for both diversification and yield improvement purposes.

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