has been shrinking over the last year and was briefly negative during intra-day trading in May. We believe the spread compression reflects the different motivations of investors using the various terms of bonds. The yield of 30-year Canada bonds has been remarkably stable even as shorter yields have been rising because of demand for duration from pension funds. Good investment results in recent years has left many funds well funded and they are choosing to reduce their asset/liability mismatch by adding long duration bonds. Supply of that sort of bond has been relatively limited (a $1 billion auction of 30-year Canada bonds in May was the smallest in over 20 years), which has kept a lid on yields rising. In contrast, the supply of 10-year bonds has been much greater and investors in that term tend not to be pension funds. Investors in that term, both domestic and foreign, have been anticipating additional rate hikes by the Bank of Canada and have been demanding relatively higher yields. As a result, the yield spread between 10 and 30-year issues has compressed. On a short term basis, 30-year bonds also benefitted in May from an anticipated increase in the durations of various benchmark indices due to shorter issues dropping out and coupon payments.

The federal sector returned 0.59% in the month as lower yields resulted in small price gains. Provincial bonds earned an average 1.22% in May. The preponderance of long term issues in the provincial sector meant that it enjoyed larger price appreciation because of the longer average durations. Provincial bonds also enjoyed a small narrowing of yield spreads over benchmark Canada bonds. Investment grade corporate bonds lagged government issues, returning only 0.38%. Corporate bond performance was negatively impacted by the risk-off sentiment in the month and corporate yield spreads widened an average 5 basis points in the period. Interestingly, demand for duration was also apparent in long term corporate bonds, because their yield spreads widened only 2 basis points in May. New issue supply was strong with $10.9 billion raised in the month. Just less than half of that total came in the form of jumbo deposit notes from CIBC, TD Bank, and HSBC Bank Canada, as the banks sought to raise lower cost funding ahead of the implementation of bail-in capital rules in September. High yield bonds earned 0.57% in May and preferred shares returned 0.97%.

We anticipate that bond yields will move higher in the coming months. As a result of their respective economies continuing to perform well, both the Bank of Canada and the Fed are expected to reduce the current monetary stimulus by increasing their respective interest rates at their next scheduled meetings. Bond yields should follow the lead of the central banks’ rate moves and move upward. Implicit in our forecast is an expectation that the flight-to-quality bid for bonds will dissipate. In addition, we are cautiously optimistic that a full-blown trade war will not develop and cause an economic slowdown.

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