The economic and financial backdrop remains constructive for government bonds over the near term, says a new bond strategy report from BMO Nesbitt Burns.

BMO notes that concerns about accounting practices, earnings, and leverage are weighing on equity markets and corporate bonds, despite evidence that the U.S. and Canadian economies are still improving. The U.S. economy is expected to post a 2% annual growth rate in the second quarter, and pick up only somewhat in the second half.

The economic rebound in Canada has been firmer and more resilient than in the U.S., says BMO Nesbitt Burns. “The ongoing turmoil in the corporate sector continues to favour a cautious stance on risk. Accordingly, we maintain our recommendation to underweight corporates,” it says.

BMO Nesbitt Burns says that July is expected to be a quiet month for provincial issuance. “At the present time, provinces have funded 18% of their financing needs for the current fiscal year.” Provincial spreads widened slightly during June, largely reflecting wider corporate spreads in response to the weakness in equity markets.

Corporate issuance volume in June was essentially unchanged from May at $2 billion. Movement in credit spreads continues to be event driven, says BMO. “Second quarter financial results that will start to be reported over the next few weeks are likely to be disappointing, and may add upward pressure on spreads.”

As for the asset-backed market, BMO says, “In light of the recent back-up in corporate bond spreads, asset-backed securities continue to remain a defensive strategy in a weakening credit environment. As a result, spreads have tightened. Investors looking for high quality AAA paper to offset deteriorating credits of lower quality instruments within their portfolio were more then ready for new ABS issuance.” But BMO suggests that history dictates that the summer doldrums will take effect and the ABS market will be fairly quiet.

Finally, BMMO notes that the yield curve has steepened substantially in response to the weakness in stock markets. “As a result, strip spreads of all varieties have widened to levels not seen since after September 11. We view this as a good opportunity to buy longer dated strips, since we feel that the curve will flatten.”

http://www.bmonb.com/Economics/bond/200207/