The Canadian bond market gained 0.84% in November, as the European debt crisis once again dominated economic news as the main driver of bond price movements. Canadian bonds also benefitted from month-end buying as investors sought to reinvest early-December coupon payments, as well as rebalance their portfolios in anticipation of index duration extensions.

The European debt crisis continued unabated, with investors demanding substantially higher yields especially on Italian and Spanish bonds in order to roll over those countries’ debt. Other Eurozone countries, including France, also experienced rising yields as investors worried about potential defaults. The crisis in Italy was particularly acute, as its Prime Minister Silvio Berlusconi was forced to resign and a group of technocrats was appointed to rectify the Italian deficit and establish plans to reduce its total borrowing. In contrast with Greece, Italy’s financial situation is stronger as it has a primary surplus, meaning that, prior to interest payments, the government spends less than it takes in through taxes. As well, a high proportion of Italian debt is held domestically, so it is not over-reliant on foreign investors. However, total Italian debt is considered high relative to the size of its economy, and also high relative to the ability of the rest of Europe to bail it out. As a result, the focus on Italy added a new degree of urgency to the crisis.

The debt crisis, as well as the weakened finances of governments globally, led Standard & Poor’s to downgrade dozens of the world’s largest financial institutions during November. Citing the reduced ability of governments and central banks to bail out the institutions, S&P lowered the ratings of Citigroup, Goldman Sachs, JPMorgan, Bank of America, Barclays, HSBC Holdings, Rabobank, and UBS among others.

The net effect of the European developments and the S&P downgrades was to heighten investor caution and increase concerns about economic growth in 2012. Austerity measures in Europe were widely expected to result in a recession in that region. Indeed, the recession there may already have begun. While Europe has been an economic follower rather than leader for many years, it still makes up roughly a fifth of the global economy and a recession in that region would depress global economic activity. In consequence, Canadian bond prices rose with the ongoing uncertainty in Europe.

As noted above, Canadian bond prices also moved higher due to domestic buying related to reinvestment of coupon payments anticipated in the first two days of December and changes to bond index durations. Approximately $8 billion of mainly federal and provincial coupons were scheduled to be paid on December 1st and 2nd, and many investors chose to reinvest those funds by purchasing bonds in late November for settlement in early December. The coupon payments, combined with the removal from the DEX Universe of a number of issues that mature in under a year, also meant that the index duration was going to increase about 0.14 years in early December. (On December 15th the index duration will rise a further 0.11 years as more issues are dropped because their remaining term to maturity will fall below one year.) Notwithstanding the record low yields, many investors wanted to maintain the same duration as the benchmark indices, and that led to substantial buying of longer term bonds so as to increase portfolio durations. Another trend in the market, as reported by the Investment Funds Institute, has been the redemption of equity funds to buy bond funds, which has increased the demand for bonds.

In Canada, with one important exception, the economic data indicated good growth. Third quarter GDP grew at a 3.5% pace, surpassing economists’ expectations. Sectors showing particular strength included exports, inventories and the energy sector. Final domestic demand, though, rose only 0.9%, suggesting consumer, business and government spending increases may be only moderate in the coming months. Housing starts remained robust, as condo sales were strong, but single family homes declined. Manufacturing sales and retail sales for September were also robust. Inflation fell, but less than expected, with CPI declining to 2.9% from 3.2%. The exception to the strong growth trend was in the employment data. Canada lost 54,000 jobs (following a 60,900 increase the previous month), and the unemployment rate rose to 7.3% from 7.1%.

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