The outlook for government bonds in the near term is positive, says BMO Nesbitt Burns in a new bond strategy report. 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, says Nesbitt.

Meanwhile, 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., it says. “The ongoing turmoil in the corporate sector continues to favour a cautious stance on risk. Accordingly, we maintain our recommendation to underweight corporates.”

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.”

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, ABS 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, BMO 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.”