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Why Jim Flaherty’s budget goal means it’s time to go long on Canadian bonds

Posted on Nov 14, 2013 in Mortgage Market Updates and News

Theophilos Argitis, Bloomberg News
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Finance Minister Jim Flaherty’s efforts to balance Canada’s budget over the next two years are giving rise to a buying opportunity in the nation’s longer-term bonds relative to their American counterparts.
Canada’s fiscal trajectory, coupled with concerns that the U.S. government will struggle to rein in spending, is helping the country’s 30-year bonds outperform similar-maturity U.S. securities. Since Prime Minister Stephen Harper’s Conservative government reiterated Oct. 16 it planned to balance the books by 2015, Canada’s benchmark 4.0% bonds due in 2041 have returned 0.1%, compared with a loss of 2.2% for 3.625% U.S. Treasuries due in 2043.
“The real story is on the long end,” said Ian Pollick, senior fixed income strategist at RBC Capital Markets in Toronto. “For long-term strategic investors you want to be long Canada 30 years versus the U.S. on a secular basis.”
The yield gap between the countries’ 30-year benchmarks widened to 68.3 basis points Monday, from as narrow as 54.1 basis points last month. That difference will probably expand to as much as 75 basis points, given Canada’s better fiscal outlook, Pollick said. With 30-year issuance north of the border increasing, any temporary drop in bond prices will give investors with a good entry point, he said.
“That’s when long-term strategic investors should begin to scale into that position,” Pollick said. “It should be a core trade to have in the books.”
Pollick cited as examples Newfoundland Power Inc. selling C$70 million of bonds maturing in 2043 last week, and Ontario unveiling funding plans for transit projects that will probably lead to more long-term debt issuance.
Flaherty will deliver the update at about 2:45 p.m. New York time during an event in Edmonton, Alberta. Canada’s budget deficit has narrowed more quickly than Flaherty forecast in his most recent budget eight months ago , primarily because of an unexpected drop in spending.
Canada 30-year yields have traded below U.S. counterparts since April 2009. The spread has widened over the past two years after almost disappearing in October 2011, peaking at 74 basis points in July.
Low Inflation
“People are happy to put money to work in the long end in countries with a strong AAA, low inflation, and strong fiscal discipline, and Canada fits that bill,” Scott DiMaggio, director of Canada fixed income at AllianceBernstein LP said in a phone interview from New York. “We’re still underweight in the long end but have reduced that underweight a little bit.”
Canada’s inflation rate rose at a 1.1% pace in September, close to the bottom of the central bank’s target range. Inflation has held below the central bank’s 2% target for 17 straight months.
Elsewhere in credit markets, bond desks were unstaffed Monday for Canada’s Remembrance Day holiday. The extra yield investors demand to own the debt of investment-grade corporations rather than of the federal government narrowed two basis points last week to 121 basis points, or 1.21%age points, according to the Bank of America Merrill Lynch Canada Corporate Index. Yields increased to 3.16% from 3.14%.
Provincial Bonds
Provincial bond spreads narrowed one basis point last week to 71, according to the Merrill Lynch Canadian Provincial & Municipal Index. Yields rose 6 basis points to 3.04% from 2.98%.
Corporate debt has returned 0.6% this year, compared with losses of 2.7% for provincial debt and 2.1% for federal-government bonds.
The Bank of Canada will sell C$1.4 billion of 30-year bonds Wednesday. The 3.5% debt will mature in December 2045. The previous auction of 30-year bonds, on May 22, fetched an average yield of 2.55% and a coverage ratio of 2.47 times.
Canada recorded a shortfall of C$18.9 billion in the fiscal year that ended March 31, the Finance Department said on Oct. 22. That figure is C$7 billion less than Flaherty projected in the March 21 budget, in which he also forecast a deficit of C$18.7 billion for the current fiscal year and a swing to surplus in the 2015 fiscal year.
Fiscal Cliff
U.S. lawmakers at loggerheads over the nation’s deficit levels caused a 16-day partial government shutdown last month. President Barack Obama signed legislation Oct. 17 to suspend the debt ceiling until Feb. 7. The U.S. recorded a budget deficit of $680.3 billion in the 12 months ended Sept. 30, according to figures from the Treasury Department.
Fiscal strife is feeding into economic performance. The shutdown led economists to lower their estimates for U.S. fourth-quarter economic growth to a 2% annualized rate from a 2.4% pace before, according to a Bloomberg survey released Nov. 1.
The Federal Reserve unexpectedly refrained from tapering $85 billion in monthly bond purchases at its September meeting, seeking more evidence the economy is strengthening. Economists surveyed by Bloomberg before the gathering predicted the Fed would begin reducing the pace of purchases.
While the Canada-U.S. spread is stretched relative to its 12-month range, “it may be early to jump to Treasuries,” Patrick O’Toole, a Toronto-based money manager who helps oversee C$50 billion of fixed-income assets at Canadian Imperial Bank of Commerce’s CIBC Global Asset Management unit, said by e-mail. “If ‘taper in December’ talk accelerates, it could be painful to go south of the border,” because U.S. yields would probably rise.


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