What’s Next for Government Bonds?

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Adam Ditkofsky, CFA

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Adam Ditkofsky, portfolio manager and vice-president at CIBC Asset Management.

So let’s discuss government bonds. So far this year, government bonds looking from the beginning of January to the end of August, have generated negative returns with the FTSE Canada Universe Federal Government subindex returning negative 2.2%. This of course can be attributed to the very strong above trend growth in inflation we’ve seen this year, which has caused interest rates to rise, as many global economies were able to reopen from pandemic lockdowns, largely thanks to aggressive vaccine programs.

Now what’s interesting to see is that most of this loss was generated early in the first quarter of the year, as the vaccine rollout was still in its early stages and inflation concerns were at their peak. But over the past three months, government bond yields have actually moved lower as growth expectations have fallen from their peak. The market believes that inflation will prove to be transitory, and the spread of the Delta variant has caused investors to become more cautious and question how quickly we can put the pandemic behind us.

So the same subindex has generated positive returns over the past three months of 1.3%. Provincial bonds have seen a similar pattern in terms of returns this year. Year to date, the provincial subindex is down 3.8%, but over the past three months, is up almost two and a half percent.

Now a better way to look at provincial bonds is to look at the provincial spreads, which is the difference between yield between Government of Canada bonds and provincial bonds. And if we look at long provincial spreads, we’ve seen them tightening from 83 basis points at the beginning of the year to a tide of 66 basis points in June, and have since modestly widened at the end of August to 74 basis points.

So again, a similar pattern. A high level of optimism early in the year, modestly subsiding as growth expectations came down from their peaks, and concerns surrounding the Delta variant have increased.

Overall, we are underweight in government bonds, both Federal and Provincial relative to our benchmark, and maintain a healthy overweight in corporate bonds, which we expect will continue to outperform Government of Canada bonds over the next 12 months. However, I would point out we still have a large exposure to government bonds, which continue to provide us with solid liquidity and support in periods when markets become more risk averse.

One exception is that we’re overweight Government of Canada agency bonds, which in our case mainly reflect our exposure to bonds issued by the Canada Mortgage and Housing Corporation, or CMHC, which are explicitly guaranteed by the Canadian Federal Government. These bonds offer investors additional spread relative to Government of Canada bonds with only modestly less liquidity, which enhances the overall yield of our portfolios.

In terms of our outlook for these bonds and for the rest of the year and into 2022, we continue to expect above trend growth for GDP and inflation, but down from the elevated levels we saw earlier this year. Ultimately over time, we should see real GDP growth return to more normalized pre-pandemic levels of sub 2% and inflationary pressures should also come down as transitory supply chain disruptions clear.

Now we don’t anticipate seeing either the Federal Reserve or the Bank of Canada raise their policy rate at least until the second half of 2022, which should support short-term bond yields staying near current levels for most of the year. We should also see longer term bond yields move only modestly higher, capped by slowing inflation and GDP compared to levels we’ve experienced earlier this year.

From a fundamental basis, all the provinces continue to have large deficits as they address the recovery from the pandemic, but many have recently revised their budgets with less [inaudible 00:03:48], which should be positive for provincial bonds in the near term.

So overall, we continue to believe government bonds make up an important part of our portfolio, but we continue to believe corporate bonds will outperform as investors benefit from higher yields in the current economic backdrop.