Bond markets globally rallied strongly in March as there was a flight-to-safety bid for government bonds due to bank failures in the United States and Europe which led to expectations of weaker future economic growth due to tighter lending standards. Current indicators of economic activity, though, showed continued growth, while inflation remained well above central banks’ comfort zones. As a result, some central banks, including the U.S. Federal Reserve, raised their trendsetting interest rate after the bank failures occurred. The FTSE Canada Universe and the Bloomberg Canada Aggregate returned 2.16% and 2.20%, respectively, in the month.

The U.S. bank crisis began March 8th when Silicon Valley Bank (SVB) announced a large loss on its holdings of U.S. Treasuries triggering a 25% run on its deposits in the next 24 hours. On Friday, March 10th, SVB was unable to meet withdrawal demands and the U.S. regulator, the Federal Deposit Insurance Corporation, was forced to take it over. The SVB failure triggered a flight to safety bid for bonds that was exacerbated by another bank failure the subsequent weekend. Investors worried whether a series of bank failures would follow, and depositors at other mid-sized regional banks began shifting money to very large banks and money market funds. Adding to depositors’ concerns was the news that unrealized losses on U.S. Treasuries at U.S. banks had grown from minimal amounts at the end of 2021 to over $620 billion in 2022 as the Fed raised rates and bond prices declined. U.S. regulators responded by offering substantial liquidity to banks taking their Treasury holdings at par value, rather than lower market values.

The U.S. banking crisis spread to Europe as investors became concerned about the financial strength of Credit Suisse. While it appeared to have sufficient liquidity, Credit Suisse’s share price plummeted, thereby sharply reducing its apparent equity capital. As a result, the bank’s contingent convertible bonds (known as CoCo bonds) were completely written off and Credit Suisse was forced to accept a takeover by UBS Group. The Credit Suisse CoCos were an unusual form of Additional Tier 1 (AT1) debt because they could be completely written off if the bank’s equity fell below a required amount. In other countries, including Canada, AT1 securities are convertible into bank common shares rather than being completely wiped out if there is financial distress. In addition, Canadian AT1 securities do not automatically convert, but require OSFI to decide the institution is not viable without the conversion. Notwithstanding the differences from CoCos, Canadian bank AT1 securities, including NVCC notes and LRCNs, experienced sharply wider yield spreads following Credit Suisse’s collapse that were only partially reversed by month end.

Canadian economic data released in March was generally favourable. Growth in Canada’s GDP during January was faster than expected at 0.5% and the annual increase accelerated to 3.0% from 2.3% a month earlier. The continued growth in activity suggested the Bank of Canada’s rate increases over the last year were not yet having the desired effect. In other news, unemployment remained at the low rate of 5.0%, housing starts were stronger than forecasts, and retail sales rebounded more than expected in January following weaker December results. Inflation was slightly lower than forecasts at 0.4% for the month and the annual CPI rate dropped to 5.2% from 5.9% the previous month. Wage inflation, however, accelerated to 5.4% from 4.5%. The Bank of Canada, meeting just prior to the SVB collapse, left its interest rates unchanged, as expected by the bond market.

The federal budget was released on March 28th, and it contained some surprises that impacted the bond market. The first was that the government anticipated running significant deficits for the foreseeable future, in contrast with last year’s budget that projected returning to a balanced budget. After the budget, the Bank of Canada projected that it would continue reducing its holdings of Canada bonds, known as Quantitative Tightening or QT, until late 2024 or early 2025. The combination of the budget and the Bank’s QT projection suggested there will be increased supply of Canada bonds in the next year, which should put some upward pressure on yields.

The second budget surprise was that the government was considering ending the Canada Mortgage Bond (CMB) programme and using Government of Canada bond issues to provide the replacement financing. While the final decision whether to stop issuing CMBs will not occur until the fall, the yield spread on the existing issues initially narrowed up to 10 basis points on the news. Provincial bond yield spreads followed the CMB narrowing. A third budget announcement dealt with the distribution of maturities of bonds to be issued in the next year. Issues of 10-year and 30-year Canada bonds will be reduced and more 2-year and 5-year bonds, as well as Treasury Bills, will be issued to raise the required funds. Another budgetary change involved eliminating the favourable tax treatment that financial institutions have on the dividends received from Canadian corporations, including preferred share dividends. While banks have relatively few preferred share investments, insurance companies have for decades been major investors in preferred shares and the budget proposal may result in a reduced allocation to this asset class.

U.S. economic data had less importance in March as investors focussed on the bank crisis and what it might mean for future economic activity. The unemployment rate rose to 3.6% from 3.4% despite very strong job creation, and wage growth accelerated to 4.6% from 4.4%. Housing starts were stronger than expected, but manufacturing surveys suggested some weakening in that sector. On March 22nd, notwithstanding concerns about the stability of the financial sector, the Fed raised its interest rates by 25 basis points. Prior to the collapse of SVB, the Fed had been expected to raise rates by 50 basis points, but the uncertainty of the impact of the bank failures led it to make the smaller change.

Internationally, the trend to higher interest rates continued. With core inflationary pressures remaining elevated, both the Bank of England and the European Central Bank raised their interest rates in March despite the turmoil with the U.S. banks and Credit Suisse. The former hiked its rates by 25 basis points while the latter increased its by 50 basis points.

The flight to the safety of bonds had the largest impact on short and mid term bonds in the Canadian market as yields of 2-year, 5-year, and 10-year bond yields fell 43 to 50 basis points in the month. Yields of 30-year Canada bonds were more subdued, declining only 18 basis points in the period. As a result, the mid term sector had a better return than either the short or long term sector of the market.  Almost all the change in bond yields occurred between March 9th and 13th, as the news of the U.S. banks’ failures rocked the market. Over the balance of the month, yields fluctuated in wide ranges but generally moved sideways as investors waited to see if the crisis was contained. In the United States, the yield curve unwound relatively more of its inversion as 2-year Treasury yields plummeted 73 basis points while 30-year yields declined 24 basis points. Remarkably, the 25 basis point increase by the Fed on March 22nd had little discernable impact on U.S. bond yields.

The federal sector of the bond market earned 2.47%, as the sharp decline in yields resulted in bond prices surging upward. The provincial sector gained 2.42% with its greater sensitivity to changes in yields (duration) being offset by a widening of yield spreads in the uncertain environment. Investment grade corporate bonds returned 1.33% in the month, as their yield spreads widened an average 24 basis points. The yield spreads of bank securities were particularly weak in March, with only a partial reversal occurring by month end as the bank crisis stabilized. Instruments lower in the capital structure, including NVCC subordinated notes, LRCNs, and institutional preferred shares, had particularly large increases in their yield spreads. Non-investment grade corporate bonds earned only 0.12% in the month, with real estate related issues having particularly weak performance. Real Return Bonds gained only 0.69% as investors were less focussed on the potential for inflation. Preferred shares declined -3.74%, hurt by both the uncertain environment and the budget proposal to tax banks and insurance companies more heavily on preferred share dividends.

As the second quarter of 2023 unfolds, we see two areas of uncertainty that are likely to dominate the attention of bond market participant for the next few weeks, if not months. The first is whether the banking crisis in the United States and Europe will become a rolling one, with more and more institutions succumbing to mismanagement laid bare by the rise in interest rates. If that were to happen, central banks might be forced to ease monetary policy, lowering interest rates in order to restore financial stability. In that event, the risk would be that inflation becomes more entrenched, making it more difficult to eradicate when central banks eventually returned to their task. We are optimistic, however, that the crisis is contained and that the additional liquidity provided the Fed and the FDIC will prove sufficient to prevent further bank failures. While we believe lending by mid-sized regional banks will be constrained for the next month or two, we do not believe that will have a lasting impact on the U.S. economy. The most likely casualty of the regional bank tightening of loan standards will be the real estate sector.

The second uncertainty will be how quickly inflation returns sustainably to the 2% target rate. We anticipate that in the next few months the annual rate may fall further as very large increases in the first few months of last year are dropped from the calculation. Indeed, the annual rate of increase in CPI could fall below 4% by June. However, the pace of recent monthly increases (0.5% in January and 0.4% in February) suggests that inflation is not yet under control. Until the monthly increases shrink to roughly 0.2% and remain there, it is premature to anticipate the Bank of Canada or the Fed cutting interest rates. Some of the factors arguing against lower inflation include China’s economic reopening, the production cuts announced by OPEC+ to raise oil prices, divergent fiscal policies, and the ongoing economic strength. We expect inflation will not return sustainably to 2% for several months, which means interest rates will have to stay higher for longer than many believe.

Currently, the Canadian economy continues to grow and is not in a recession. If the banking crisis has been contained and inflation remains sticky, bonds should reverse much, if not all, of their March rally. Consequently, we are keeping portfolio durations defensively short of their respective benchmarks. With the mid term sector outperforming in the month, we have paused increasing the allocation to mid term bonds until they retrace some of their relative gains. While growth remains positive, the need for the Bank of Canada to keep interest rates relatively high for an extended period increases the risk of a recession occurring. In that event, we would expect corporate yield spreads to widen substantially and the sector to underperform government bonds. Consequently, we are gradually reducing the allocation to corporate bonds and reducing the duration of the corporate holdings.

One area of particular concern is real estate. While private debt funds performed very well in 2022 due to their use of floating rate loans rather than fixed rate ones, the preponderance of real estate related loans may prove problematic in the coming months. We note that several private debt funds have already run into difficulty meeting client demands for withdrawals, including those run by Ninepoint, Bridging Finance, Romspen, and Blackstone. We also believe that significant numbers of borrowers are having difficulty servicing their debt resulting in 20% to 30% of some funds’ holdings accruing interest rather than it being paid. Therefore, we are minimizing exposure to real estate related borrowers. In addition, we believe that the lower credit risk and better liquidity of government bonds will prove advantageous compared to the singular reliance of corporate debt in private debt funds.