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Fixed Income Quarterly—Benchmark Barometer
We look for the Fed to begin tightening rates around the middle of next year, reflecting a tightening labour market. Even if the seeds of a wage-price spiral won’t be planted easily, and inflation on the ground and perhaps even in the FOMC’s projections could still be running sub-2%, the Fed may still want to fire a warning salvo or two across the bow of inflation expectations to temper the latter, along with bolstering its own credibility. Indeed, the inaugural rate hikes could even take on “pre-emptive” characteristics. This is what likely buoyed long Treasuries (and their perennial inflation worry), despite the prospects for sooner liftoff.
Canada-U.S. yield spreads narrowed along most of the curve in March, by as much as 13 basis points at the 3-year node. However, they widened some 6 basis points for 30 years, emphasizing the power of inflation expectations in bucking front-end selloffs. The Canadian market might have done even better if not for the shift in the Bank of Canada’s tone. In its March 5 policy announcement, the Bank said “the balance of risks remains within the zone for which the current stance of monetary policy is appropriate,” emphasizing its neutral stance. In January, the Bank had omitted the “appropriate” reference—it was there in December—raising the risk of a rate cut in the market’s mind. The Bank effectively shut the door on rate cuts, with Governor Poloz starting to reach for the locking key given recent comments (he’s “a little more comfortable” about inflation).
Yields on both sides of the border look to continue drifting higher during the months ahead on the combination of con- tinued tapering of Fed asset purchases (we judge QE will end by this Q4), sustained stronger U.S. economic performance that should eventually support the Canadian economy, and the prospects for policy rate hikes around the middle of next year (with a net risk the BoC could go before the Fed owing to the Canadian economy sporting a significantly smaller output gap than the U.S.).
More New Issues, but Still Not Enough
There were over $8 billion worth of additions and re-openings to the corporate segment of FTSE TMX Canada Universe Bond Index during March, but even that was not enough to curtail the torrent of buying activity that has taken place all year. It has mattered little about risk-on versus risk-off, or whether yields have been backing up or narrowing. Investors want corporate bonds of all shapes and sizes. As a result, the
modest backup in underlying Canada yields during March did little to dampen enthusiasm for corporate bonds, propelling Broad Corporates to a total return of 0.13% in the month and making it the best-performing segment. By comparison, the Broad Composite incurred a negative total return of -0.19%, while Broad Government registered a total loss of -0.33%. Strong demand during March saw spreads for Broad Corpo- rates draw narrower by three basis points.
We have spoken at some length in other reports about the factors creating the demand/supply imbalance in corporate bonds, the most prominent being the entry of significant new buyers (e.g., international investors and short-term corporate bond funds) over the past number of months. The slow start to the year for corporate new issuance exacerbated the impact of these new players, who last year catapulted the primary market for corporates into a new stratosphere. The disrup- tion to that new issue flow has dragged corporate spreads to multi-year lows, with no let-up in sight. We expect demand for corporate bonds to remain strong over the near term and note that buying has been relatively indiscriminate across maturity and credit quality.
With regard to ratings buckets, Broad Corporate BBB was the best-performing segment during March, posting a total return of 0.31%. What’s more, the total return of each corpo- rate ratings bucket beat out each of the government segments in the index during the month, demonstrating that investors were interested in adding spread product. However, the de- sire to assume extra risk was not only apparent in terms of credit ratings, the move to add duration was also equally quite evident. While the total losses incurred by the government segment worsened as one moved out the maturity buckets, quite the opposite happened with corporates, with the strong total returns being recorded in the long end. In fact, the total return of 0.65% registered by long Corporate BBB was by far the best performance of all index segments in March. Fatter coupons and a scant availability of product helped to drive that outperformance. Indeed, investors have demonstrated a distinct reluctance to sell BBB bonds for fear of not being able to get them back given the disequilibrium in the market. This occurrence speaks to our assertions from last year that the BBB and high-yield portions of the corporate market have developed their own characteristics, separate from the dynam- ics in the higher-rated buckets.
On a year-to-date basis, the strong performance in March thrust the 2.95% total return of Broad Corporates ahead of