Bond markets are well behaved this year, generating solid returns because of Canada’s improving fiscal situation and stable macro-economic fundamentals. The Bank of Canada recently raised short-term rates by 25 basis points to 2.75%, yet most managers remain optimistic about returns, which they admit will be somewhat lower than in the recent past.

“Canada has opened up a tightening cycle, although the U.S. Federal Reserve Board has been at it since June 2004,” says Bruno Bourgeois, lead manager of Altamira Bond
Fund, Altamira Income Fund and National Bank Bond Fund.

U.S. short rates have risen to 3.5% from 1%, but he expects they will climb to 4% by late fall. In Canada, “there may be another 25-bps increase, pushing rates to 3% later this fall,” says Bourgeois, who is also senior vice president, fixed income, at Montreal-based Natcan Investment Management Inc.

The U.S. economy began slowing before Hurricane Katrina, while Canada’s is growing and Europe’s is relatively slower, he says. “It’s not very robust on the economic side.
Also, core inflation has been trending down in the last six months,” he says, noting that domestic inflation is under 2%, “but we are facing significant headwinds.”

Bourgeois is concerned not only about monetary tightening in the U.S. but also about
oil, which at around US$63 a barrel is slowing economic momentum. “Various measures of consumer confidence have been weakening,” he says, noting that salary increases are flat, the U.S. housing market is cooling and retail behemoth Wal-Mart
Stores Inc. has admitted that the high cost of energy is cutting into consumer purchasing power.

“All three factors are significant headwinds. It seems to me the risk is becoming somewhat asymmetric — that is, on the lower side. We are more prone to see bouts of weakness than a significant re-acceleration of the economy,” he says, adding that the key driver is core inflation. Still, while short rates have been increased, he admits he is comfortable with bonds in the longer maturities. “The market is fairly priced.”

The yield curve has been flattening in the past 12 months as long bonds are down about 90 bps and yielding just above 4%. Based on the observation that the Scotia Capital Universe Index is yielding close to 4%, Bourgeois says investors should expect similar returns. “Going forward you have to expect lower returns.”

Altamira Bond is a long-term bond fund that aims to benefit from higher yields available at the longer end of the yield curve. Its duration is 12.75 years, compared with 6.4 years for the benchmark Scotia Universe Bond Index. About 40% of the portfolio is invested in provincial bonds (mostly B.C., Ontario and Quebec), 40% in Government of Canada bonds and 20% in corporate bonds.

The most significant strategic move in the last year has been the reduction of federal bonds, which used to account for about 47% of the fund. “You can get additional yield in the provincial market,” Bourgeois notes. “Although spreads have tightened there, we remain fairly comfortable with provincials.” He has also raised the corporate exposure by about 3% in the past year, although he regards the current level as neutral. “Spreads have tightened significantly but we are not concerned in the short term because balance sheets are very healthy.”

Meanwhile, Altamira Income Fund’s duration is 6.5 years. About 25% of the portfolio is held in provincial bonds, 31% in corporates and 44% in federal bonds. “Our bias is to buy on weakness in the market, so at times we are more likely to be longer than shorter,” Bourgeois says. “This ties into our view of the economy, which is more likely to show signs of weakness than strength.”

The bond market is still favourable, says Geoff Wilson, co-manager of TD Canadian Bond Fund and vice president of Toronto-based TD Asset Management Inc. Looking at the U.S., for instance, “we’re finding the market as a whole is continuing to look for yield. Baby boomers want to reduce some of the risk in their portfolios and match their assets and liabilities,” he says. “Pension funds have also made a shift in moving their assets to long-term bonds … driving up prices.”

In Canada, the fundamentals have caused 10-year bond yields to drop to 3.8%, or even lower than in the U.S., where comparable bond yields are about 4.2%. Pointing to the continuing Canadian budget surplus, Wilson says, “That’s very positive for our economy. But, in the U.S., the budget deficit could be US$200-US$300 billion for the next decade. That makes it hard to push spending, whereas we are paying down our debt and running a surplus. That means the government can pour money into the economy.”

@page_break@Although short-term rates in Canada could move to about 3%-3.25% over time, based on the Bank of Canada’s announcements, Wilson says the central bank could be cautious about further rate increases beyond the two 25 bps hikes expected this fall.
“That’s especially the case with the C$ approaching US85¢.”

Meanwhile, core inflation is 1.6%, or at the lower end of the range set by the Bank of Canada. Based on this factor, as well as strong demand for yield, he says it is not likely that long bond yields will drop significantly. “We will see some movement in interest rates, but are we into a trend of higher rates at the long end? I don’t see that,” he says.

Looking ahead, and echoing Bourgeois, Wilson cautions investors to expect lower returns. “Performance has been driven by capital gains. So if yields don’t continue to fall, it only makes sense that we will start looking at returns that are significantly lower.”

From a strategic viewpoint, Wilson and co-manager Satish Rai, vice chairman, TDAM, have allocated about 62% of TD Canadian Bond to corporate bonds, a weighting that has been consistent for some time. The bonds provide an additional pick-up in yield over government securities. Fully invested, they have split the remainder roughly equally between federal and provincial bonds. For additional diversification, they are
also holding about 10% in real return bonds which mature in 20 years or more.
Excluding the latter portion, the fund’s duration is a neutral 6.4 years.

The fund’s assets have grown more than 40% in the last year, so its managers have been faced with the challenge of investing the cash. What is more, as it is difficult to add to the 100-plus existing investment-grade corporate issues (which few investors are willing to trade because of the high yields), they have had to scout out new
opportunities. Most are in the financial services market.

One recent acquisition has been HSBC Bank Canada Capital Trust. A hybrid instrument, it matures in June 2015 and yields 4.5%, or about 75 bps over government treasuries. “HSBC has a very strong franchise in Canada and a strong partnership with its parent, HSBC Plc.” Another new holding is Wells Fargo Finance Canada Corp. , the finance arm of San Francisco-based Wells Fargo, a leading diversified financial
services player. Maturing in June 2015, it is yielding 4.25%.

The Canadian yield curve will continue to flatten, says Janet Vandierendonck, co-manager, London Life Income Fund, and vice president, fixed income, London, Ont.-based London Life Investment Management Ltd.

“Canada is quite steep compared with other countries, but has some flattening to do.
Most of it will come at the short end as we expect short interest rates will keep rising,” she says. While there is a 30 bps spread between U.S. short and long bonds, the spread in Canada is about 100 bps.

The fund is 69% invested in bonds, plus 6% in cash and 25% in more than 50 dividend-paying common equities, such as Manulife Financial Corp., BCE Inc. and TD Bank.
Rob McCrindle, vice president of equities at LLIM, manages the equity portion. The bond exposure is weighted toward corporate and provincial bonds — which account for 43% and 35.5% of the fixed-income portion, respectively — because of the fund’s income orientation, says Vandierendonck. Federal bonds account for 21.5%. The overall duration is 6.4 years.

“It’s not that we are cautious on Government of Canada bonds. It’s that we really like the additional spread you get over Government of Canadas. That is our primary focus,” she says, noting investment-grade corporate bonds yield about 25 to 45 bps above federal bonds.

“Of late, having the overweight in corporates and provincials has been the best strategy,” adds Vandierendonck. “But we are tending to the front end of the yield curve and have been overweighting bonds in the short- and mid-term sectors.” The latter strategy is a way to deal with credit quality and minimize any damage if spreads start to widen. “We might see spreads widen out so we are picking very high quality bonds.”

Running a 100-name bond portfolio, Vandierendonck likes GE Capital Canada Funding, which has an AAA-rating. “It’s a very liquid security with a stable credit outlook. It’s a good defensive bond,” she says, noting the 2008 issue is yielding 3.35%, or 22 bps above federal bonds. IE