Federal bonds returned +0.05% in November as coupon income offset the lower prices brought on by higher yields. Provincial bonds returned +0.86%, benefitting from lower long term yields and an average 6 basis point narrowing in yield spreads versus benchmark Canada bonds. Investment grade corporate bonds returned +0.65% in the month. Demand for corporate issues remained strong, as their yields spreads narrowed by 7 basis points. New issue supply was moderate, at only $6.1 billion. High yield bonds gained +0.53% in November, while Real Return Bonds returned +0.77%, modestly outperforming nominal bonds on a duration-adjusted basis. Preferred shares continued to rebound from their August lows, earning +1.18% in November.

As this is being written, the Bank of Canada has announced that, as widely expected, it is leaving its trendsetting interest rates unchanged. With inflation on target, unemployment at a historically low level, and the economy growing at a satisfactory pace, the Bank saw no reason to adjust its current monetary stance. In addition, the Bank said it thought the global economy was stabilizing. While there are risks that Canadian growth may slow further, the high levels of household debt argue against lowering rates. In addition, the minority status of the federal government makes it likely that there will be increased government spending and that increase in fiscal stimulus will make additional monetary stimulus unnecessary. The December 5th Throne Speech should provide some indication of how much fiscal stimulus is coming.

While the Bank of Canada’s overnight target interest rate provides something of an anchor for short term bond yields, yields of longer term bonds are being influenced heavily by external factors, especially the U.S./China trade dispute and Brexit. While forecasting the ebbs and flows of the trade negotiations (including the erratic overnight tweets) is virtually impossible, the strong need of both sides for some sort of a deal makes it the most likely outcome. The timing of a partial settlement of the dispute is, of course, nebulous, but we think most likely to occur by the end of the first quarter of next year. When it is announced, bond yields should move markedly higher but, until then, the recent volatility will likely continue. In Great Britain, the December 12th election is expected to result in the Conservative party regaining a majority, which should then lead to a quick decision to follow through with the negotiated agreement to leave the European Union. Uncertainty about the impact on the British and European economies will continue to fuel demand for the safety of bonds. That demand has been flowing through to the Canadian bond market because our yields are relatively attractive to many international investors. It will take a few quarters to assess the impact of Brexit, so its influence on bonds will unwind slowly.

The volatility caused by the trade disputes and Brexit makes us reluctant to take an extreme position with regard to duration. However, we do believe the ultimate direction for bond yields will be higher, so we are keeping portfolio durations shorter than the respective benchmarks.

The yield curve remains saucer-shaped with mid term yields below those of both short and long term bonds. This relationship should not last very long. Unless the Bank of Canada begins lowering interest rates soon, which we do not expect, mid term and long term bond yields will face increasing upward pressure. Accordingly, we are structuring the portfolio to benefit from a steepening of the yield curve.

We do not anticipate a recession in the next year, so we are comfortable with an overweight allocation to corporate bonds. However, we recognize the potential for a slowdown has increased, so we are carefully reviewing the creditworthiness of every holding and looking for opportunities to lower overall risk. Current yield spreads are relatively narrow compared with the experience of the last decade. In other words, the risk/reward trade-off is not particularly favourable. Accordingly, we are monitoring the market for opportunities to reduce the corporate exposure in the portfolio.

1 2