During October, federal bonds returned -0.53% as the higher yields resulted in price declines. The provincial sector earned -1.06% in the period. The yield spreads of short and mid term provincial bonds were little changed, but long term spreads widened 2 basis points in the month. Investment grade corporate bonds returned -0.61%. The credit curve, which shows how corporate risk premiums (yield spreads) increase as the term of the bonds lengthens, also steepened in October. Strong demand for short term corporates resulted in their yield spreads narrowing by 3 basis points, while long term corporate spreads widened by 5 basis points. New issue supply of $8.8 billion was readily taken up by investors, but most new issues failed to tighten more than a few basis points despite being heavily over-subscribed. High yield bond investors were apparently oblivious to the worsening pandemic and rising government bond yields during October; non-investment grade bonds gained +0.78% in the month. There were two new issues of high yield bonds, one a Limited Recourse Capital Note for Canadian Western Bank and the second a 5-year bond for Russel Metals. Real Return Bonds earned -0.77%, which was markedly better than nominal bonds on a duration-adjusted basis. Preferred shares suffered the same risk-off sentiment in the final week of the month as gains turned to small losses. Over the whole month, preferred shares returned -0.38%, marginally better than both government and corporate bonds.

We do not see any reason to change our outlook from last month: the pace of the recovery was likely to slow even before the onset of the pandemic’s second wave. However, with the pace of infections and hospitalizations rising in many jurisdictions, the reimposition of social distancing restrictions and business closures is increasingly likely. At this time, we do not anticipate the full shutdown measures that occurred in March and April, but the recovery is likely to become a slow, grinding one rather than a rapid one. Even if a vaccine against the coronavirus is proven effective and safe before the end of the year (our fervent hope!), manufacture and administration of sufficient doses of the vaccine would probably take until mid-2021. Only then are social distancing restrictions likely to be fully lifted and a full economic recovery become possible.

We are pleased that the Bank of Canada finally began adjusting its QE, both because its sheer size has at times distorted the Canadian bond market by preventing appropriate pricing of risks by investors and because it has not encouraged any hint of fiscal restraint by the federal government. We anticipate that the changes by the Bank will result in further steepening of the long end of the yield curve. Indeed, as this is being written, the Bank has announced that it will no longer buy Canada bonds with less than 2 years to maturity, a major change because heretofore the majority of the Bank’s bond purchases had been in that maturity bucket. At the same time, the Government of Canada has announced a reduction in the size of its 2-year bond auctions from $7 billion to $5 billion as it tries to lengthen the average term of its debt. With the Bank now focussing on purchases of bonds maturing in 3 to 15 years, yields on 20 and 30-year Canada’s are at risk of increased supply from the government which should lead to higher yields. We are structuring the portfolios in anticipation of the yield curve steepening. We are also keeping durations slightly shorter than benchmarks as a defensive strategy.

We believe corporate yield spreads are not properly discounting the economic and financial risk in the current environment. We prefer, therefore, to be conservative in selecting corporate issues, focussing on higher quality issues and reducing exposure to BBB-rated bonds. In the short run, we may give up some yield by focussing on higher-rated issues, but elevated risk levels make that the appropriate strategy.

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