Preferred shares suffered another weak month, with the S&P/TSX Preferred Share index returning -5.56%. Rate reset issues fell 6.08%, while floating rate issues dropped 5.06%. Perpetual issues continued to outperform, declining only 1.67%. As with corporate bonds, relatively attractive new issues caused outstanding issues to be repriced lower. In particular, two new rate reset issues came to market in the month and, for the first time, set a floor on their respective dividend rates. That feature made them attractive relative to all previous rate reset issues, and encouraged further selling of existing issues. Tax loss selling may also have been a factor in the market decline.

We observed that liquidity in corporate bonds was relatively low in September. That suggests using caution when evaluating index pricing of individual issues. In periods of reduced liquidity, the index often is slow to widen yield spreads on less frequently traded issues. As a result, the index price tends to be higher than where an actual sale would occur.

The Fed’s inaction in September was simply delaying the inevitable, in our opinion. The U.S. economy is growing reasonably well, albeit with occasional hiccups, and unemployment is low. The current extraordinarily low interest rates are not appropriate and should be raised. We continue to anticipate that the Fed will start raising rates at its December meeting. Unfortunately, that probably means another two months of volatile markets as investors interpret economic data for clues to the Fed’s intentions and react to further contradictory statements from Fed officials.

The federal election campaign has not yet had much effect on the Canadian bond market. We believe the greatest impact is likely to occur immediately after the results of the election are known. Historically, markets do not like uncertainty, and a change of government, if it occurs, would likely cause investors to become more cautious, at least until the new government’s policies are developed and accepted.

In terms of portfolio strategy, we believe that higher yields are the greater risk rather than lower ones, particularly for longer term bonds. That is because Canadian long term bond yields will likely follow U.S. bond yields higher and the market may well move in advance of the Fed. Accordingly, we are keeping portfolio durations shorter than benchmarks. However, the difference is relatively small due to the uncertainty that volatility brings. The recent widening of provincial and corporate yield spreads has made both sectors more attractive, but we are refraining from adding to either until we see spreads stabilizing.

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