If you think Canadian yields are low, check out Germany or Japan

David Stonehouse, vice president and member of the fixed-income team at AGF Investments Inc. He is responsible for a wide range of income-generating mandates including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond.

Michael McHugh, vice president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond.

David Gregoris, managing director, fixed-income at Beutel Goodman & Co. Ltd. His mandates include Beutel Goodman Income, Beutel Goodman Short-Term Bond and Beutel Goodman Long-Term Bond.

This three-part series concludes on Friday.

Q: Have the major central banks in the developed world exhausted their monetary policy options?

Stonehouse: The European Central Bank is out of bullets. The Bank of England has little room to do more than it already did after the Brexit vote.

McHugh: The Bank of England is likely to sustain this easing bias as the UK navigates through the uncertain consequences of the referendum’s vote to exit from the European Union.

Gregoris: Brexit also creates uncertainty for the European Union, which already has its fair share of economic and financial challenges. The European Central Bank, for example, would like to foster increases in lending to small and medium-sized business, which generate 80% of the employment growth within its borders. But the ECB’s problem is that there are some serious issues with the banks in certain EU countries, most notably Italy. It will likely have to continue its quantitative-easing strategy to stimulate the economy and give some sort of relief to financial institutions.

Q: What about the Bank of Japan, which has waged a long-standing battle against deflation?

Stonehouse: Japan’s central bank has acknowledged that it has gone about as far as it can go with its negative policy rate and negative yields in Japan’s fixed-income market. It recognizes that there is a negative impact of this on its financial institutions.

Waiting in the wings is so-called helicopter money. It is not the same as quantitative easing. Here the debt purchased by the central bank still exists. Someone has to pay the interest and repay the principal on the security. With helicopter money, in the form being considered, there is no interest and no need for the debt to be repaid. The concept is that the government would issue a perpetual bond with zero interest, which the central bank would buy and hold indefinitely. The proceeds would then be used to retire existing sovereign debt. It is essentially the monetization of government debt. It is sleight of hand.

Q: The U.S. Federal Reserve Board, as we have discussed, is in an enviable position versus its peers, given the relative strength of the U.S. economy. But, there is some uncertainty surrounding the November U.S. presidential election.

McHugh: Most material to financial markets are the appointees of the president and the policies of the U.S. administration. These will not be clarified or evolve until 2017. Any post-election response will thus be reactionary and short term. The impact on financial markets is, therefore, likely to be transient and the focus will quickly shift to the economy and to global issues.

Gregoris: The narrative that some candidates are running on is disturbing, if you believe in free markets. There is talk of the fight against globalization and free trade. I am concerned about protectionism.

Q: We have discussed the trends in central-bank monetary policy and the impact on the global fixed-income markets. What is the outlook?

McHugh: We will remain in a global low-yield environment. Valuations, linked to central-bank policies, are currently expensive. This is creating conditions of bouts of higher volatility. The extension of the duration in global markets, as a result of these low interest rates, will add to that volatility. (Duration, expressed as a number of years, is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates.)

Q: What are examples of yields on 10-year government bonds going around the developed world?

Stonehouse: At recent count, the 10-year Government of Canada bond had a yield of just over 1%.

McHugh: 10-year U.S. Treasuries were yielding 1.55%.

Stonehouse: The 10-year German Bund had a yield of a negative seven basis points (100 basis points equals 1%). Japan’s 10-year bond had a negative three basis points.

McHugh: For shock value, Switzerland’s 10-year bond had a negative 55 basis points. UK gilts had a yield of about 70 basis points.

Q: This UK yield was roughly half of that prior to the June 23, Brexit vote of 137 basis points.

Stonehouse: It is a huge move down.

Q: These are all nominal yields, without the adjustment for the rate of inflation. What is the real yield, for example, on the 10-year Government of Canada bond?

McHugh: It is negative adjusting for the inflation rate in Canada of around 2% per annum. This speaks to the expensive valuations on these securities. These negative real yields are depreciating the value of the security over time. A government bond is not very attractive as a long-term investment. The case for it is dependent on the expectation of further declines in yields, thereby generating capital gains.

Stonehouse: Or if there is deflation or the expectation of a currency gain.

McHugh: There have been a number of recent issues with negative nominal yields by corporations looking to tap the Euro bond market. An example is the German consumer-goods group, Henkel AG.

Q: In July, Canadian Imperial Bank of Commerce became the first Canadian bank to issue bonds designated in euros, with a negative nominal yield. From an investor’s standpoint, given the disparity in bond yields between countries, with some of them negative, there must be a preference for Canadian, U.S. and UK bond markets?

Stonehouse: The Anglo-Saxon countries do have higher yields and that is attractive to foreign investors. The flow of foreign funds into these bond markets has increased significantly over the past number of years.

Q: What about investor preferences this year for the different issuer classes? Let’s focus on the Canadian investment-grade bond market this year? These are those securities that attract a BBB credit rating and above.

Stonehouse: Triple-B corporate bonds have been in demand this year. Increasingly these have constituted the majority of the corporate issuance available. This is partially a consequence of corporations being able to issue into a willing market and partially due to lower corporate-credit ratings, as corporations increase their leverage. That has spilled over into the high-yield market. We have had a very substantial rally in corporate bond markets over the last six months, both investment grade and high yield.

McHugh: There has been a dash for trash.

Gregoris: The corporate bond market has become bipolar. It goes from exuberance, as it is today, where everything sells, to no-bid where there are few buyers of certain product and aggressive sellers.

McHugh: There has been a strong demand for corporate debt despite the backdrop of late-cycle credit conditions. Corporate earnings are deteriorating, there is increased financial leverage and companies that were previously unable to access debt markets are able to do so. When the fundamentals resurface, this is likely to result in a dramatic collapse of corporate bond prices and rising credit spreads.

Q: We should turn now to the performance of the Canadian fixed-income benchmark. The FTSE TMX Canada Universe Bond Index tracks the performance of investment-grade securities, which attract a BBB credit rating and above.

Stonehouse: This index had a total return of 5.02% for the first eight months of this year and total return of 5.76% for the 12 months to the end of August.

Q: Bonds underperformed the Canadian equity market over these two periods. The S&P/TSX Composite Index produced a total return of 14.43% for the first eight months of the year and 8.69% for the 12 months to August end.

Stonehouse: That is correct. When looking at the relative performance of the different issuer classes in the Canadian investment-grade bond market, it is best to look at the FTSE TMX mid-term bond index, bonds with maturities of five to 10 years. This removes the impact of duration on performance.

Corporate bonds were the top performers in this index over the first eight months of the year, with a total return of 5.72% as well as for the 12 months to the end of August, with a total return of 6.26%. These bonds comfortably outperformed this mid-term index over these two periods. Provincials were second. They had a total return of 4.4% for the eight months to the end of August and 5.38% for the 12 months to the end of August. Their performance was quite close to that of the index.