The turmoil in the Middle East and North Africa, particularly Egypt and Libya, caused bond prices to rise in the second half of February. One reason for the upward pressure was the flight to the safety of bonds that often occurs in uncertain times. Investors generally prefer to reduce their exposure to risk when the future is less certain and the potential spread and unpredictable result of the democracy protests led to purchases of bonds. A second reason for rising bond prices was that the upward spike in energy prices that occurred due to the unrest in a number oil producing countries caused concerns that the economic recovery would falter as a result. Interestingly, the potential inflationary impact of higher prices for energy and other commodities was largely ignored by the market. Apparently, investors believed there was too much spare capacity in the economy for cost-push inflation to take hold or that the inflationary pressures would be temporary.

The Canadian yield curve flattened in February as 2-year benchmark Canada bond yields rose 15 basis points, while 30-year Canada bond yields fell 3 basis points. The increase in shorter term yields was the result of strong economic data prompting investors to anticipate Bank of Canada rate increases sooner than previously expected. The decline in longer term yields, on the other hand, reflected an even stronger rally in 30-year U.S. Treasuries following the large mid-February Treasury auctions that were well received by domestic and foreign buyers.

The corporate sector was the best performing one during the month, gaining 0.46%. Notwithstanding new issue supply of $4.6 billion in February, good investor demand caused corporate yield spreads to narrow 5 basis points. Financial issues fared particularly well as the Office of the Superintendent for Financial Institutions issued guidance on capital requirements to comply with the Basel 3 agreement, thereby addressing investor uncertainty. Provincial bonds returned an average of 0.43%. Provincial yield spreads narrowed only 1 basis point, but that sector’s longer average duration meant that it had greater gains associated with the decline in long term yields. Trailing the performance of the corporate and provincial sectors were federal bonds, which lost 0.01% in the month.

We believe that the economic expansion will continue to absorb remaining spare capacity and lead to lower unemployment, increased consumption, and higher bond yields. The Bank of Canada seems likely to resume its rate increases at either its May or July meetings, with a total of 75 to 100 basis points of increases before the end of the year. Bond yields are expected to rise in advance of the Bank of Canada rate hikes, with short term yields vulnerable to the largest increases. Timing of the Bank’s moves will be dependent on the level of our exchange rate, and that may depend on whether other central banks are also in tightening mode. In the United States, the Federal Reserve is unlikely to raise rates before the fourth quarter at the earliest, but we anticipate that more rapid job creation will lead to increased speculation about the Fed’s timing and that will cause bond yields to increase.

We have taken a number of steps to position the portfolio defensively. To minimize the impact of higher yields, duration has been shortened to a year less than the benchmark, and further reductions are likely. Holdings of short term bonds have been replaced with money market investments in order to preserve capital. Corporate bond holdings represent a much greater proportion of the portfolio than the benchmark, because their yield spreads are historically wide and offer the potential of future capital gains. In addition, the higher yield earned on the corporate bonds offsets the lower current yield of the money market holdings. We have also initiated a position in Real Return bonds, because we believe that short term inflationary risks have increased.

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