The Canadian yield curve steepened slightly in the month, as 10 and 30-year Canada bond yields rose 6 basis points while 2-year yields were only marginally higher. The relatively small changes belie the volatility during the month: 10-year Canada bond yields were 17 basis points higher than the previous month during the Bank of Canada policy uncertainty, before receding into month end.

Corporate bonds were the best performing sector in October, gaining a meagre 0.01%. On average, corporate yield spreads narrowed 1 basis point, which offset the impact of slightly higher benchmark yields. Federal bonds declined an average 0.15% in the period, as the price declines resulting from higher yields were greater than the interest earned. Provincial bonds were the worst performing sector, declining 0.43%. Provincial bonds were hurt by their longer average durations (which meant larger price declines as yields rose), as well as a 1 basis point widening of their yield spreads.

In the last few years, the bond market has generally rallied in November and December. A significant factor behind this seasonality has been the demand for long-term bonds by mismatched life insurance companies and pension funds to compensate for the growth in the present value of their liabilities brought about by falling bond yields. Wanting to take corrective action prior to their fiscal year ends, the lifeco’s and pension funds have bid up long duration bonds. In addition, index duration extensions and coupon payments scheduled for December have created demand for bonds at a time when supply traditionally decreases.

We believe the forces pushing bond prices higher during November and December in recent years will be more muted in 2012. Asset/liability demand for duration would appear lower this year, presumably because of past efforts to improve matching. In addition, index duration extensions are projected to be more subdued, because the Government of Canada has been gradually shifting some of its maturities away from the traditional June and December cycle. Accordingly, we believe the bond market is unlikely to break out of its trading range in the near term. Of course, a substantial surprise result in the U.S. elections might result in some short term volatility, but we do not anticipate bond yields and prices will move substantially until the president-elect and the new Congress start addressing the twin problems of the fiscal cliff and the federal deficit.

In the first 10 months of 2012, corporate bonds have returned an average 5.39%. That was substantially better than federal and provincial bonds, which earned 1.91% and 2.75%, respectively. Investor demand for higher yielding corporates caused yield spreads to compress markedly even as new issue supply has been robust. Accordingly, we believe that the risk-return trade-off of corporate bonds is much less compelling than earlier in the year and we will look to selectively take profits in corporate issues that have, in our opinion, rallied too far, too fast.

Yield Spread of 10yr A-rated Corporate Bonds

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