The Canadian yield curve flattened further in September as yields of short and mid term Canada bonds rose more than 30-year bond yields. The yields of 2, 5, 10-year bonds each rose between 21 and 23 basis points in the month, while 30-year yields rose only 11 basis points. As a result, the yield of 30-year Canada bonds fell below that of 2-year Canada’s for only the third time in the last 30 years (the previous occasions were January 2000 and May 2007). The rate cut by the Fed kept U.S. Treasury yields from recovering much of the large declines of August. Yields of Treasuries rose 11 to 17 basis points in the month.

Federal bonds returned -0.89% in September as higher yields resulted in lower bond prices. Provincial bonds returned -1.02%, with their longer average duration offset by smaller yield declines for long term bonds. The yield spread between provincial and federal bonds narrowed by 3 basis points in the month. Investment grade corporate bonds fared better than government bonds, returning -0.54% in the month. Demand for corporate issues was strong, as their yields spreads also narrowed by an average 3 basis points notwithstanding robust new issue supply of $13.2 billion fixed rate bonds. High yield bonds, which tend to track equity markets, gained +0.55% in September as stock prices rose in the period. Real Return Bonds returned -0.94%, which meant they outperformed nominal bonds on a duration-adjusted basis. Preferred shares recovered most of their August losses, gaining 3.34% in September. The preferred share rebound was due in part to the rise in 5-year Canada bond yields.

Both the Bank of Canada and the Fed are scheduled to announce their respective interest rate decisions on October 30th. Barring an unexpected deterioration in their respective economies, we believe both central banks will leave rates unchanged. In any event, the timing so late in the month reduces their potential impact on the bond market during October.

Trade negotiations between China and the United States are supposed to resume in mid-October. While the negotiations will likely remain difficult and result in continued volatility, there is increasing pressure on both countries to agree to a deal that will, in turn, ameliorate concerns about a global recession. When that happens, bond yields should rise from present levels. We are, therefore, maintaining portfolio durations somewhat shorter than benchmarks but, given the volatility of the markets, we are not making a large bet on duration at this time.

The yield curve is currently saucer-shaped with mid term yields below those of both short and long term bonds. We do not expect this to last very long. Eventually, the yield curve should normalize, with mid term yields above those of shorter term issues. Unless the Bank of Canada begins lowering interest rates soon, which we do not expect, mid term bond yields will face increasing upward pressure. Accordingly, we are shifting the portfolio yield curve exposure to reduce the expected impact of higher mid term yields.

We do not anticipate a recession in the next year or so, so we are comfortable with the current overweight allocation to corporate bonds. However, we recognize the potential for a slowdown has increased, so we are carefully reviewing the creditworthiness of every holding and looking for opportunities to lower overall risk. We continue to avoid the retailing sector and retail-oriented real estate issuers, and the recent bankruptcy of Forever 21 just confirms the difficulty bricks-and-mortar stores are having competing with internet-based shopping. We are also concerned that demand for traditional office space may decline as firms permit more employees to work from home. So, we are cautious regarding real estate issuers in general.

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