After a hiatus of several months, the fragility of the European Union again caused some volatility in the bond market. The new Italian coalition government proposed a budget that seemed to ignore Italy’s already massive accumulated debt and challenged the EU’s budget guidelines. The budget led to a brief flight-to-safety bid for higher quality government bonds in Europe that flowed into North American bond markets. However, the impact dissipated within a day or two as European debt crises no longer have any novelty for bond investors.

The Canadian yield curve moved higher in September with yields of all maturities rising by similar amounts, a pattern which was quite similar to a larger move in the U.S. yield curve. The yields of 2 and 5-year Canada bonds rose by 14 and 17 basis points, respectively, while 10 and 30-year yields climbed 19 and 17 basis points. At the end of the month, 10-year yields closed slightly above 30-year ones for the first time since 2007. The inversion of long term bond yields appears to be the result of demand for long duration assets by pension funds and life insurance companies exceeding supply.

The federal sector returned -0.83% in the period, as interest income could not offset the price declines brought on by higher yields. Provincial bonds returned -1.25% on average; a 2 basis point narrowing of provincial yield spreads partially offset the impact of the sector’s longer average duration. Investment grade corporate bonds earned -0.79% as their yield spreads tightened by a basis point in September. There was $10.0 billion of new corporate supply in the month, with large issues from Canadian banks accounting for slightly more than half of the total. Two banks squeezed in the final deposit notes before the September 23rd implementation of new capital regulations while the Royal Bank was the first out of the gate issuing new bail-in type bonds. The bail-in structure explicitly contemplates potential conversion to equity in the event of the financial distress, but the bonds rank ahead of subordinated Non-Viability Contingent Capital (NVCC) notes in an insolvency. (Of passing interest, Moody’s has confusingly named the new bail-in bonds Junior Senior Unsecured debt) The new Royal Bank bail-in bonds were issued with a yield spread roughly 13 to 15 basis points wider than deposit note spreads, which seemed fairly tight to us, and despite large demand for the issue it failed to rally after pricing. Non-investment grade corporate bonds earned 0.23%, thereby outperforming higher quality issues. Real Return Bonds returned -1.47% but outperformed nominal bonds on a duration-adjusted basis. Preferred shares returned -0.33% in September.

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