Bond markets hit a rough patch in the spring after central banks jacked up interest rates to stem inflationary pressures. Fund managers say prospects could improve, however. The U.S. economy is showing signs of slowing and its once-robust housing sector is under mounting pressure as new homebuyers become scarce.

“Is the U.S. economy slowing? Our answer is ‘Yes’,” says David Gregoris, co-manager of Beutel Goodman Long Term Bond Fund and vice president of Beutel Goodman & Co. Ltd. in Toronto. Gregoris works with lead manager Bruce Corneil, senior vice president and chief operating officer at Beutel Goodman.

In the first quarter, U.S. GDP grew 5.6%, but then slowed to 2.5% in the second quarter. “The economy is decelerating to around 2.5% growth,” he says. “The issue in the Federal Reserve Board’s mind is that you don’t want to increase rates, then quickly decrease them, causing panic. It has gone to the side, which makes a lot of sense.”

Gregoris says the Fed’s strategy is to have mild or non-inflationary growth, and be a lender of last resort if there is a problem: “But, if [Fed chairman] Ben Bernanke sees markets having problems, he will lower rates.”

Britain and Australia also raised rates, partly to curtail their own housing booms, with no adverse economic effect. But, he says, it is not certain if the U.S. will follow suit.

“Our best guess for now is that the economy continues on a slow-growth basis and doesn’t slip into recession,” says Gregoris, who is keeping a close eye on the housing slowdown, which could worsen and put a crimp in the economy. Moreover, he questions whether the recent 5.25% central bank rate in the U.S. is too high. If core inflation goes higher than the recent 2.5%, Gregoris says, Bernanke will increase short-term rates.

“If inflation was a problem, he might raise rates another 100 basis points to slow it down,” he says. “But it doesn’t appear to be a problem.”

Gregoris says U.S. long-term bond yields of 4.9% look fully valued: “Our positioning is that if the economy slows, we’ll see a steepening of the yield curve. The risk is that inflation is a bona fide problem and weakens the U.S. dollar, which leads to inflationary pressures. It may cause longer rates [in the U.S.] to rise.”

Canada is more fortunate, he adds. The Bank of Canada is under less pressure to raise rates because core inflation is under control and the country enjoys strong GDP growth rates.

Strategically, Gregoris is being moderately defensive, and his stance is reflected in the fund’s duration of 11.8 years, compared with 12.4 years for the benchmark Scotia Capital Long Term Bond index. In terms of asset mix, there is 50% in provincial bonds, 40% in corporate bonds and the remainder in Canada bonds. In contrast, the benchmark has 44% provincials, 21% corporates, and 35% federal bonds. The federal bond portion is underweighted, he notes, because corporate and provincial bonds offer slightly higher yields.

Moreover, he is emphasizing regulated utilities. The top 15 holdings, which account for 87% of the portfolio, are dominated by bonds issued by Westcoast Energy Inc., Enbridge Pipelines Ltd., TransCanada PipeLines Ltd. and CU Inc. The bonds are trading at 100 bps to 120 bps above long-term federal bonds.

“Not only are we using a shorter duration, but also a higher credit exposure,” he says. “Over the past 10 to 15 years, that is an attractive spread level.”



The spring was painful to the bond market but conditions improved over the summer, says James Dutkiewicz, manager of CI Long Term Bond Fund and vice president of CI Investments Inc. in Toronto.

“The market feels more comfortable with the amount of tightening being done around the world. Even markets such as India and South Korea have been tightening,” he says. “There was a need to reduce liquidity and prevent an inflation scare because energy and commodity prices have been stubbornly high.”

The second factor, he adds, is the realization that the U.S. housing market may be slowing more than some expected.

“No one knows the degree. In-ventory levels are high and prices are falling on a month-over-month basis, although they are up about 2% on a year-over-year basis,” says Dutkiewicz.

“Real estate is no different than other markets. If you have more supply than demand and prices are falling, people will hold off on their purchases,” he says.

@page_break@The big concern in the U.S., he notes, is that financial institutions became very creative in their mortgage underwriting and effectively drove housing prices much too high. “There is a fear that U.S. consumers will buckle under the strain of high energy prices and relatively high interest rates, without the ability to tap the equity in their homes,” he says. “If the U.S. consumer rolls over, the Federal Reserve Board could be forced to lower rates in the next six months.”

Although he says the U.S. housing market could do with a correction, Dutkiewicz doesn’t share the bearish views of those who expect the Fed will be compelled to lower rates to ease the pressure. “The environment around us, globally, is much stronger than it was five years ago. Real yields are low, and monetary policy is mildly restrictive or neutral, globally speaking.”

“Everything outside of the U.S. housing issue is looking good. Is the story so bad and the repercussions so negative that they overwhelm the positive factors? I think the jury is out,” says Dutkiewicz. “The U.S. bond market may be saying, ‘The Fed has to ease rates soon.’ I don’t necessarily share that view.”

Moderately bearish on bonds, Dutkiewicz has raised cash to about 10%, largely because cash is yielding slightly more than long-term bonds. The CI Long Term Bond Fund’s duration is nine years. That is slightly shorter than the 9.4 years for the fund’s benchmark, a 50/50 blend of the Scotia Capital Universe Bond Index and Scotia Capital Long Term Bond Index.

In terms of asset mix, the fund has an underweighted 37% position in Government of Canada bonds, is underweight 36% in provincial bonds and is overweight 27% in corporate bonds. He has added to the corporate component lately for several reasons.

“My bias is that the global economy is still performing well and credit quality is still good. The biggest risk is the fallout from mergers and acquisitions; bonds have been known to suffer after a takeover,” he says, noting the impact on Dofasco Inc., whose bonds were hurt after its takeover by lower-rated Arcelor SA. “We’re trying to avoid takeover candidates.”

Running a 55-name fund, Dutkiewicz favours a number of educational institutions that are fully backed by provincial governments and yet offer slightly higher yields than the provinces.

“Some of the universities have higher credit ratings because they have large endowments,” he says. For instance, a Queen’s University bond, which matures in 2032, yields 4.9%. Similarly, he owns a 2042-dated McGill University bond, which yields 5%.

On the corporate side, Dutkiewicz owns Greater Toronto Airport Authority, which matures in 2029 and yields 5.3%, and Molson Coors Inc., which matures in 2015 and yields 5.1%. There are also a number of bonds issued by financial institutions such as Royal Bank of Canada.



According to Geoff Wilson, co-manager of TD Canadian Bond Fund and managing director of TD Asset Management Inc. in Toronto, “We’re in a holding pattern, but there are signs of weakness, especially in the U.S. economy. The signs are evident in the consumer and housing market.”

He adds that “there’s a significant slowdown in the new home market, which will cause the U.S. economy to pause. It remains to be seen what the ramifications will be. The U.S. is such a large consumer that it could slow the global economy.”

It is too early in the game, says Wilson, to predict the degree of the slowdown, but the yield curve is already inverted in both Canada and the U.S.

“Clearly, the market is of the opinion that the Fed is on hold for now, and it is starting to price in some decrease in short-term rates mainly as a reaction to an expected slowdown in the economy as a result of the housing slowdown,” he says.

Although consumer confidence indices are already falling, he notes it will take time before it’s clear that GDP growth is also slowing.

“The bond market is assuming that the Fed has raised rates too high and will at some point next year need to reduce them,” says Wilson, noting the market has rallied on such an expectation in September.

He says the housing slowdown could potentially spill over into equity markets, and push down consumer confidence levels even further. “This would be the next step, and things could deteriorate. Interest rates could drop across the board and prices could rally significantly.”

Strategically, Wilson and lead manager Satish Rai, vice chairman at TDAM, have long emphasized corporate bonds in the fund. Currently, such bonds account for about 62% of the portfolio. There is also about 18%-20% in federal bonds and 18% in provincial bonds. They are maintaining a neutral stance in terms of duration as it is equivalent to the benchmark SC Universe Index’s 6.4 years.

Although a weakening economy could have a negative impact on corporate bonds, Wilson says, “It won’t have much of an impact on the strongest companies, so we have been upgrading our credit portfolio and going for higher quality bonds.”

Among the recent credits are government agencies such as Farm Credit Canada, which lends to farmers across the country. The AAA-rated bond matures in 2021 and yields 4.5%. “It’s a government bond and an example of how we can pick up extra yield,” he says.

Another recent acquisition is AAA-rated Alberta Capital Finance Authority, which matures in 2016 and yields 4.4%, or about 20 bps over Government of Canada bonds.

The fund continues to have large positions in bonds such as the 2012-dated securities issued by Manulife Financial Capital Trust, which yields 4.72%, and Sun Life Capital Trust, which has a 2011-dated bond that yields 4.7%. IE