Canadian bonds join rout, poised to underperform as rates jump

Investors in Canada’s $700-billion government debt market are bracing for additional losses, possibly outpacing U.S. declines, as Bank of Canada governor Stephen Poloz gears up for several rate increases over the next year.

While the short-term focus is on employment and inflation data in the U.S. and Canada, the signing of a new NAFTA and a $40-billion LNG project by Royal Dutch Shell Plc changed the “longer-term” sentiment, said Romas Budd, vice-president and head of fixed income at 1832 Asset Management. 1832 Asset is a unit of Bank of Nova Scotia.

“There is a real chance for Canadian bond market under-performance in the next couple of months,” said Budd, who has shortened the duration of his Canada bond portfolio. “It’s kind of funny that issuers have been preparing for that for quite a long time, but it seems to me that the buyside haven’t really believed that rates were about to go up and stay up.”

Canada bonds have outperformed the U.S. this year, even after yields in both countries soared this week on expectations the Federal Reserve and Bank of Canada will boost rates to tame inflation as the economies heat up. The Bloomberg Barclays Canada Aggregate bond index has declined one per cent this year, half the drop of the comparable U.S. index.

The yield on Canada’s benchmark debt maturing in 2028 rose to 2.55 per cent, the highest in more than four years on Wednesday, according to data compiled by Bloomberg. Yields on two-year notes were unchanged, a day after hitting a decade high of 2.31 per cent.

“We are tactically short at the moment and looking to cover before non-farm payrolls,” said Mark Carpani, head of fixed income at Toronto-based Ridgewood Capital Asset Management. After “being aggressively short during this latest downdraft, it’s time to take some profits and reload.”

The Bank of Canada last tightened monetary conditions in July, increasing its overnight lending rate to 1.5 per cent. The benchmark is likely to end the year at 1.75 per cent, according to a Bloomberg News survey. The next announcement is set for Oct. 24, with swaps trading implying a 97-percent chance of a hike.

“For a move materially higher from here, inflation expectations will have to improve,” said Ryan Goulding, a fixed-income manager at Vancouver-based Leith Wheeler Investment Counsel Ltd. Canadian bonds’ “near term pricing to me looks very fair when I look at what is now priced in for the BOC.”

Not all fund managers expect Canadian bonds to under-perform the U.S., betting that the Fed will move more quickly on rates than the Bank of Canada. “The BOC is not as aggressive in removing accommodation as the FOMC,” said Sean Simko, head of fixedincome portfolio management at SEI Investments Co, who expects Canadian and U.S. rates to move in similar fashion.