Following four months of sideways movement, bonds broke out of their trading range in April, with prices moving higher and yields declining. In large part, the catalyst for lower yields was the flagging optimism about the U.S. economy. The combination of weaker than expected economic data, the chaotic performance of the new Trump administration, and the inability of the U.S. Republican Party to agree on major policies such as the repeal of Obamacare, caused investors to lose confidence in the anticipated economic acceleration from the implementation of Trump’s election promises. Canadian bond yields lowered, following U.S. bond yields. The FTSE TMX Canada Universe Bond index returned 1.43% in April.
Following a few months of relatively strong data, Canadian economic news received in April were a little softer. Canadian economic growth in the most recent month (February) was reported flat, although the year-over-year growth increased to 2.5% from 2.3%. Retail sales were weaker than expected due to lower gasoline prices and reduced purchases of automobiles. Other sectors experienced increased sales. Inflation was also lower than forecasted, declining to 1.6% from 2.0% the month earlier. The Bank of Canada (BOC) did the expected and left interest rates unchanged. The BOC acknowledged the strength of economic data in recent months, as Governor Stephen Poloz said that any further rate cut was unlikely in the foreseeable future.
Sabre-rattling by the U.S. government on trade matters caused the Canadian dollar to drop 2.5% against the U.S. dollar in the month. President Trump threatened to pull the United States out of the North American Free Trade Agreement as a bargaining strategy, before negotiations begin on amending the treaty. In addition, the decades-old software lumber dispute resurfaced, as the U.S. Commerce Department imposed tariffs on Canadian lumber, following the expiration of a ten-year truce between the two countries.
In the United States economic news was somewhat disappointing. First quarter GDP growth came in at an annual rate of only 0.7%, below already diminished expectations. U.S. growth in the last year was only 1.9%, notably slower than the Canadian rate. U.S. personal consumption increased at an annual rate of only 0.3%, which was concerning. Weaker than expected retail sales confirmed that consumers were reluctant to spend. New job creation was also weaker than forecasted, but the unemployment rate fell to a cyclical low of 4.5%. The weaker data, on balance, caused U.S. bond yields to decline and prices to increase, as Canadian bonds followed suit.
The Canadian yield curve flattened in the month as the 30-year bonds yields fell 15 basis points, while 2-year bond yields declined only 3 basis points. The existing proximity of 2-year bond yields, at 0.72%, to the BOC’s 0.50% overnight target, made larger declines unlikely. The biggest change in bond yields occurred in mid-term issues, with 10-year bond yields moving 19 basis points lower in the month. With yields of all maturities dropping, the federal sector enjoyed good price appreciation and returned 1.00% in the month. The provincial sector, which is primarily comprised of long-term bonds, gained 1.82% in the month, aided by provincial spreads narrowing 2 basis points on average. The investment grade corporate sector returned 1.53% in the month, outperforming both government sectors on a duration-neutral basis. Corporate yield spreads narrowed 5 basis points on average as new issue supply of $6.2 billion failed to satisfy investor demand. Non-investment grade corporates fared less well, gaining only 0.39%. Real return bonds, which have very long durations on average and benefitted from lower yields, returned 2.11%. Preferred shares, which had a very strong first quarter, took a breather in April, returning 0%.
Late in the month, Home Capital Group, an alternative mortgage lender, experienced a sudden liquidity crisis. Ontario Securities Commission allegations of misconduct by three current and former executives in 2014 and 2015 led to a run on Home Capital’s high interest savings accounts. News that the company then agreed to a usurious bailout loan from a large pension fund only reinforced the appearance of severe financial distress. However, the problems seem contained to Home Capital and the impact on the bond market has been minimal, save for a sharp loss in the value of Home Capital’s own bonds.
NexGen Canadian Bond Fund
Favorable security selection improved returns as several long-term corporate holdings experienced better than average spread narrowing. Yield curve positioning, which overweighted mid-term issues and underweighted short-term bonds, also contributed to the Fund’s performance. The sector allocation, which emphasised corporate bonds, further improved results. The slightly shorter duration of the portfolio reduced returns somewhat.
During April, we purchased a new Goldman Sachs Maple bond at an attractive spread. The Goldman Sachs bond matures in 2023 but is expected to be redeemed in 2022. Other transactions included the sale of some Canada 2029 bonds to slightly reduce the fund’s duration.
Market Outlook and Strategy
While we agree with the consensus that the Trump administration will have considerable difficulty delivering on election promises to raise economic growth, we believe too much credence is being given to the slower economic activity in the first three months of the year. Weaker U.S. economic data in the first quarter of the year is hardly a new phenomenon. First quarter GDP growth initial reports have been much lower than economists’ forecasts in each of the last 8 years. Perhaps wonky seasonal adjustment factors are to blame, but in most cases growth has rebounded over the balance of the year. We suspect that the pattern will repeat itself in 2017. Accordingly, we are being patient regarding portfolio durations, preferring to remain slightly shorter than the benchmarks.
The corporate sector has been our preferred sector as yield spreads have been attractive. As those spreads have compressed, corporate bonds enjoyed price gains relative to their underlying Canada benchmark bonds. However, the narrowing of corporate spreads over the last several months has brought them to the tightest levels since the financial crisis. At this point, corporate bonds appear fairly valued, but are no longer “cheap” in our opinion. As can be seen in the chart below, deposit note yield spreads have been narrower on occasion in the past, but relatively infrequently. The same is true of the spreads for other types of corporate issues, such as long-term utility bonds. Lower probability for yield spreads to narrow reduces the likelihood of enhanced returns due to capital gains, so we are evaluating whether to reduce the allocation to the corporate sector.
For more information about NexGen Canadian Bond Funds, please contact your financial advisor.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.
This release may contain “forward-looking statements” which reflect the current expectations of NGAM Canada LP and/or its sub-advisor, J. Zechner Associates Inc. (“J. Zechner”). These statements reflect the applicable management’s current beliefs with respect to future events and are based on information currently available to such management. Forward-looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements including, without limitation, those listed under the heading “Risk Factors” in the NGAM Canada LP NexGen Funds prospectus, which is available on NGAM Canada LP’s website and on SEDAR at www.sedar.com. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward-looking statements contained in this release. Although the forward-looking statements contained in this release are based upon what NGAM Canada LP and/or J. Zechner believes to be reasonable assumptions, NGAM Canada LP and J. Zechner cannot assure investors that actual results, performance or achievements will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this release and NGAM Canada LP and J. Zechner do not assume any obligation to update or revise them to reflect new events or circumstances.
NGAM Canada LP is the manager of the Fund and is an affiliate of Natixis Global Asset Management S.A.