An interesting anecdote regarding foreign interest in Canadian bonds surfaced last month. The Swiss National Bank has been concerned about the weakness of the Euro versus the Swiss franc for several months, because of the negative impact on Swiss exporters. Earlier this year, the SNB decided to hold its exchange rate with the Euro constant, which involved massive sales of Swiss francs to purchase Euros and other currencies. As a result, between April and July, the Swiss central bank nearly doubled its holdings of foreign currencies, as they increased by over €170 billion. If the SNB kept its allocation to Canadian dollars at the same level that existed prior to this massive foreign exchange intervention, it would have resulted in it buying $5 billion Canadian dollars. Those Canadian dollars would then have had to have been invested in Canadian fixed income securities. Discussions with a number of Canadian investment dealers lead us to conclude these flows probably did in fact occur. The impact of this central bank’s and numerous other ones’ ongoing interest in Canada as a safe haven has had the twin impact of substantially lowering our bond yields and elevating the Canadian exchange rate.

Investors ignored the weaker economic outlook and continued to have strong demand for corporate bonds. Although new issue supply was robust at over $8 billion in the month, corporate yield spreads narrowed an average 6 basis points during September. As a result, the corporate sector was the top performing one in the period, gaining 0.86%. Provincial spreads narrowed by 3 basis points, which combined with their longer average duration, propelled them to an average 0.83% return. For much of the month, Quebec bonds outperformed those of other provinces, because of lack of supply. The change in government following the election put Quebec new issuance on hold for a few weeks, which led to tighter spreads versus other provinces. Near month end, however, Quebec resumed its borrowing with two issues in quick succession; these caused Quebec spreads to widen again. Federal bonds trailed the other sectors, earning only 0.43%. The yield curve steepened slightly as shorter term yields fell modestly, while longer term yields declined less.

The Canadian bond market has been in a trading range for the last two months and we anticipate that may extend for a few more months. Demand for Canadian bonds as a safe haven from foreign investors is likely to continue, because the European debt crisis is unlikely to be resolved soon. As well, domestic demand for long term investments from mismatched defined benefit pension funds and life insurance companies will also be supportive of Canadian bond prices. In addition, with global growth still decelerating, Canadian economic growth is likely to be subdued, which will be positive for the bond market. That said, we believe that with yields near historic lows, bonds are not particularly attractive; and downside risk is greater than upside potential. We will, therefore trade the range from a neutral to short stance.

Yield of 10 yr Canada Bond

Corporate bonds remain our favoured sector, because their yield spreads are still historically wide. However, the recent rally in corporate bonds has resulted in significant narrowing of spreads, which is somewhat perplexing given the worsening economic outlook. Given that China’s economy is still decelerating, Europe is mired in recession, and the U.S. is approaching its fiscal cliff, the risk for Canadian growth is slower, not faster. Typically, weaker growth puts pressure on corporate profitability, which leads to increased concerns about creditworthiness and wider yield spreads. Accordingly, we believe there is some risk that corporate bonds give back some of their recent gains in the next few months. Should corporate spreads tighten further, we will consider reducing the corporate allocation.

With the increased likelihood of slower economic growth going forward, we are being especially vigilant regarding creditworthiness. We are avoiding issuers with significant European exposure, and we are cautious about U.S. issuers. We have also reduced potential exposures to a weaker Canadian housing market.

Looking at the yields available at different terms, bonds maturing in 3 to 5 years appear to be overvalued. Yields on Canada bonds in those terms are between 1.10% and 1.30%, little more than the 1.00% overnight target of the Bank of Canada, and essentially discounting any rate increases for several years. While we do not believe that the Bank of Canada will raise rates until mid-2013 at the earliest, we think that rates and yields will eventually need to rise. Current yields of 3 to 5-year bonds offer little protection from that eventuality, so we are minimizing holdings of those terms.

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