Yields of benchmark Government of Canada bonds fell at all maturities, with mid term bonds experiencing the greatest declines. Yields of 5 and 10-year bonds dropped 36 and 39 basis points, respectively, while 2 and 30-year yields declined roughly 30 basis points. Demand for shorter term bonds came from global central banks, as well as international hedge funds that were forced to cover money-losing short positions that had anticipated Bank of Canada rate increases. Longer term bonds (i.e. 10 to 30 years) rose in price in anticipation of early-June duration extensions of DEX Universe and DEX Long Term Bond indices. In contrast with the near parallel shift in the Canadian curve, the U.S. yield curve flattened dramatically as 2-year Treasury yields were unchanged, but 30-year Treasury yields fell 44 basis points. In both countries, the yields of longer term bonds finished at record lows.

Federal bonds returned 1.98% in the month, with long term Canada issues gaining a remarkable 4.99%. Provincial bonds earned 2.69%, as their longer average durations meant they enjoyed larger price gains as yields fell. The positive impact of longer durations was partially offset by a 6 basis point widening of provincial yield spreads. Corporate bonds lagged both government sectors, rising 1.69% in May. The economic uncertainty and weak equity markets caused corporate yield spreads to widen 10 basis points, thereby resulting in smaller price gains during the bond market rally.

We currently hold several high yield issues for clients that permit their use. One issue, Ford Credit Canada, enjoyed particularly good returns in May, because of developments at its parent company, Ford Motor Company. Ford’s ongoing financial improvement was recognized by Moody’s in May, as the agency raised the bonds to investment grade. This action followed a similar upgrade of Ford by the Fitch rating service in April. The rating upgrades prompted additional demand, which lifted the price of the bonds.From time to time, clients ask us about the advisability of using high yield, or non-investment grade, bonds in their portfolios. We have been active in the high yield market since 1997, providing significant experience on which to base our opinions. Fundamentally, we believe the addition of non-investment grade bonds to a fixed income portfolio can be beneficial, subject to two caveats. First, the investment manager must be very capable in credit analysis. Last year, there were at least eight Canadian high yield issuers that experienced significant credit events, and the only protection for investors was if their manager possessed the skill and experience to avoid each one. The second caveat regarding high yield investments is to make them a part of a broader investment mandate, such as an investment grade Canadian bond portfolio, rather than as a specialized high yield mandate. There are not enough non-investment grade issuers in Canada to construct a well-diversified portfolio, so a high yield fund manager is generally forced to hold as much as half of the portfolio in U.S. high yield issues. That unfortunately entails accepting additional risks that can detract significantly from returns. In the chart below, the returns of investment grade Canadian bonds, as measured by the DEX Universe Bond Index, are compared to the returns of the Merrill Lynch High Yield Master II Index, a widely used U.S. high yield index. To make the comparison more accurate for Canadian investors, the U.S. high yield results were adjusted for changes in the Canada/U.S. exchange rate. As can be seen in the chart, U.S. high yield bonds, as an asset class, have been more volatile with lower overall returns than Canadian investment grade bonds. That suggests that U.S. high yield bonds should not be included as a separate asset class, nor as a component of an overall high yield mandate. Instead, selective use of high yield issues, within a broader fixed income portfolio, would appear to be the optimal way to benefit from the occasional opportunities that occur in these securities.

Canadian and US bonds - Returns

Current bond yields are not attractive. However, we do not anticipate a significant correction in bonds over the near term. The extension of index durations will continue until June 15th, putting upward pressure on long term bond prices. As well, uncertainty about the Greek political impasse will likely remain for at least a few days after the June 17th election. Similarly, speculation about the fiscal health of other European countries will continue to cause a flight-to-safety bid for Canadian bonds. Accordingly, we are keeping portfolio durations close to benchmark levels. Longer term, we believe yields will rise, but that may not occur until there is greater evidence of a recovery in the U.S. housing sector as well as more progress in resolving the European sovereign debt crisis.

We also believe the recent selloff in the Loonie, if it lasts, will make it easier for the Bank of Canada to raise interest rates somewhat. We substantially reduced the holdings of cash equivalents in the last few weeks, which benefitted the portfolios. However, with 5-year Canada yields currently below 1.25% and close to the Bank of Canada’s 1.00% target, we anticipate selling some shorter term bonds in favour of more defensive money market positions.

The economic outlook for Canada for the balance of 2012 is not robust, but it is satisfactory. With corporate yield spreads at historically attractive levels and economic conditions favourable, we are comfortable with an overweight allocation to corporate bonds. Provincial sector weightings have increased following the widening of provincial yield spreads, but the longer average duration of provincial bonds is not attractive given our longer term view that yields will rise. We anticipate reducing the holdings of Real Return Bonds in the near term to avoid the temporary impact of the recent drop in energy prices. However, we remained concerned about the risks of excessive inflation, noting that Canadian CPI increased at a 5% rate through the first four months of this year. With monetary policy still very stimulative, there is little to prevent an acceleration in inflation. We will monitor it closely with the view to potentially rebuilding the RRB holdings.

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