The selloff early in September saw the yields of mid and long term bonds in Canada and the U.S. each rise by more than 20 basis points. In the process, Canadian bond yields hit their highest levels since July 2011. The post-Fed rally, however, reversed those yield moves. Yields of benchmark 2-year Canada Bonds declined 2 basis points over the whole month, while 30-year Canada yields finished only a basis point higher. Mid-term Canada yields fell roughly 8 basis points, reflecting even sharper declines in U.S. Treasury yields. U.S. 5-year yields, for example, fluctuated in a very wide 47 basis point range, as they initially rose 24 basis points, but eventually finished 23 basis points lower. Canadian yields followed the direction of U.S. yields, but with smaller moves.

The small overall decline in yields helped the federal sector return 0.46% in September. The provincial sector enjoyed slightly narrower yield spreads versus benchmark Canada Bonds and that resulted in the sector gaining 0.72% in the period. Corporate yield spreads, on the other hand, widened slightly and that held their average returns to 0.40%. New issue supply of corporate bonds remained strong at $12.6 billion. Highlights included $1.6 billion raised by Loblaw to help fund its Shoppers Drug Mart acquisition and $1.25 billion Bank of Montreal deposit notes. Real Return Bonds continued their annus horribilis, declining a further 0.16% in September, which brought their year-to-date return to -11.42%. Low Canadian inflation has reduced demand for the protection of RRB’s.

As this commentary is being written, the partial U.S. government shutdown has begun. We do not believe, however, that the shutdown will have a lasting impact on the economy. In the last 35 years, the U.S. government has gone through 17 such shutdowns with little long term effect on economic growth. While growth initially slows as a result of the shutdown, it quickly recovers following the resolution. We also think that the likelihood of a U.S. default because of the debt ceiling negotiations is remote. However, the threat of a default may lead to volatility in the markets until it is resolved.

In last month’s commentary, we noted the possibility that the Fed would not begin reducing its bond purchases in September, and that is indeed what occurred. The substantial reaction to the lack of tapering, in our opinion, represents only a correction in the current bond bear market, rather than a change of underlying market direction. The U.S. economy continues to strengthen and the Fed will eventually need to slow the pace of its bond purchases. Whether tapering is announced at the Fed’s meeting late in October or it is delayed until early 2014, it is still going to occur and that should lead to some further increase in long term bond yields.Yield of Canada 10 Yr Treasury

Accordingly, we are keeping the portfolios defensively positioned, with durations significantly shorter than the benchmarks. We believe, though, that the bond bear market is more than half over. In particular, we feel that the potential yield increases going forward are less than the moves that have already occurred since May. With central banks, including the Bank of Canada, reluctant to raise interest rates for at least the next year, we think there is a limit to how far longer term yields can rise. We also believe that future yield increases are likely to be slower, which means interest income will offset more of the price declines, thereby improving returns.

The pace of Canadian economic growth has been disappointingly slow. But we are optimistic that global growth is starting to accelerate and that bodes well for Canada’s export-oriented economy. Corporate creditworthiness remains good and corporate yield spreads are attractive. We are, therefore, maintaining the relatively high allocation to corporate bonds in the portfolio.

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