The Canadian yield curve flattened slightly in May as 10 and 30-year Canada bond yields each fell 22 basis points, while 2-year yields declined only 13 basis points. The shift in Canadian yields was notably less than U.S. yields which plunged 34 to 37 basis points across the yield curve. By the end of the month, almost all Canada bond yields were below the Bank of Canada’s overnight interest rate of 1.75%; only 30-year yields, at 1.77%, remained above the Bank’s target. With yields of most federal bonds well below the target, investors are apparently anticipating that the Bank will be lowering its interest rate in the coming months.

Federal bonds returned 1.36% in May as lower yields resulted in higher bond prices. The provincial sector benefitted from its longer average duration and earned 2.29%. Provincial yield spreads edged a couple of basis points wider in the period. Investment grade corporate bonds earned 1.31% in the month. Their returns trailed those of government bonds because corporate yield spreads widened an average 4 basis points in the more uncertain environment. New issue supply was lighter than normal at $6.1 billion in the month and that helped limit the spread widening in the month. The risk-off sentiment in May caused high yield bonds to underperform investment grade issue, returning -0.47%. Real Return Bonds earned 1.91% in the month; on a duration-adjusted basis they underperformed nominal bonds because investors anticipated slower global growth would result in reduced inflationary pressures. Preferred shares declined -3.00% in the month, hurt by declining common share prices and lower bond yields.

The Bank of Canada believes that Canada will not fall into a recession this year, barring further unanticipated shocks to the global economy. We concur. Indeed, the Canadian economy is expected to experience a growth rate in excess 2% in the second quarter, following two quarters of disappointingly slow growth. As a result, we believe the Bank of Canada will not be changing its trend-setting interest rates, either up or down, this year. The Bank will be in good company, as the U.S. Federal Reserve is unlikely to change its rates either. While the policies of U.S. president Trump are wholly unpredictable, we believe that as the 2020 election nears, the resultant need to maintain good economic growth will lead to fewer shocks and reduced impediments to growth, including tariffs.

We believe that as the Canadian economy continues to exhibit positive economic growth, the pessimism that pushed Canada bond yields below the Bank of Canada’s 1.75% overnight target will dissipate and yields will rise. Accordingly, we have positioned the portfolios defensively, with durations modestly shorter than their respective benchmarks. The yield curve is inverted from Treasury Bills to 5-year bonds, making mid term issues the most expensive on the yield curve. Accordingly, we are shifting the portfolio away from the mid term sector and into a combination of short and long term issues. Our sector allocation strategy is maintaining a moderate overweight of the corporate sector, but we are looking to further improve overall credit quality given the current stage of the economic cycle.

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