Strategists reducing exposure to bonds

The central banks of both Canada and the U.S. will likely raise interest rates over the short-term before the tightening cycle relents, according to forecasters at BMO Economics.

“We look for the Fed to raise the funds target 25 bps to 4.75% at the March 28 FOMC meeting, reflecting concerns about the inflation risks posed by diminishing spare economic capacity and the cumulative increase in energy prices,” reads a research note released by the BMO team.

“As the spring months unfold, the smell of sub-par economic performance will be in the air, as consumer spending weakens under the weight of higher energy bills and rising debt-service costs, along with sharply slower house price inflation.”

The group forecasts the rate will remain stable at that level until the end of the year, when the prediction is that the Fed will begin cutting rates. The Bank of Canada is expected to raise its key overnight rate twice from its current 3.5%, hitting 4% in April.

So what does this mean for fixed income investors?

For the coming year, ending January 2007, BMO predicts Government of Canada bonds to slightly underperform cash in terms of total returns, as capital losses of 36 basis points eat into yield. Short and long bonds are seen returning 3.77% and 3.71% respectively, with mid-duration issues offering 3.67%. Cash, on the other hand, is expected to provide a return of 3.94%.

BMO’s own domestic fixed income strategy at present is to overweight short and long bonds, 41.2% and 33.8%, respectively. Mid-duration bonds make up 25% of the portfolio, a 4% underweighting from the benchmark.

Despite rising interest rates, Canadian corporate issuance totaled $7.2 billion in January alone, double that of December 2005. In the past five months, new issues totaled $33 billion, with 85% of that coming from firms in the financial sector.

Underperformance in many corporate sectors leads BMO to recommend underweighting the asset class by 3%, with a 1.5% overweighting in both federal (48.4% of portfolio) and provincial (27.7%) government bonds.

With predictions that cash will outperform government bonds, it should come as no surprise that the experts are shying away from fixed income.