Bond Fund

Quarterly Comment (March 31, 2012)

The first quarter of 2012 saw a new wave of optimism flow into the equity and corporate bond markets as the European debt situation was contained and US economic data slowly began to improve. Canadian and US bond markets still had a few aggressive and volatile moves, but overall remained largely range bound. The yield curve continued to flatten as the market finished pricing out rate cuts from the third quarter flight to quality and slowly began pricing in rate hikes. The Bank of Canada left rates unchanged, but progressed towards becoming a little hawkish towards the end of the quarter. The US Federal Reserve left rates unchanged as well during the quarter, but was still able to cause several major market moves. The market was focused on the sustainability of US economic growth and whether a third round of quantitative easing would be necessary. This put a premium on Fed statements and led to several aggressive moves in the market on Fed communiqués. During the first quarter US yields increased as the flight to quality continued to be unwound and US economic data strengthened. Canadian yields increased as well due to improved economic data and investor sentiment which caused investors to move cash out of bonds and into equities.

The portfolio was concentrated in mid and long Canada bonds with a duration that was generally shorter than the benchmark. The short duration position, short-term trading and an overweight allocation in corporate bonds were the drivers of out performance for the quarter. Yield curve positioning had little impact on performance while an overweight allocation in provincial bonds subtracted value.

The Canadian yield curve flattened throughout the quarter as the market finished pricing out interest rate cuts and began pricing in hikes. The flattening trend will likely continue as volatility subsides further. The US yield curve was little changed on the quarter. We have a position on the yield curve that favours mid and long-term bonds as short bonds do not look attractive here. Credit spreads rallied significantly during the quarter as European debt crisis fears calmed and investor confidence returned. We expect credit spreads to consolidate here until there is more clarity on the sustainability of the recovery. Our longer dated corporate names are made up of infrastructure and utilities which have predictable cash flows and are “recession resistant”. Our mid-term corporate names are focused on banks.

We are bearish on bond prices over the medium-term as yields are still not far from historic lows. We believe that volatility will remain in the market until early Q3 2012, as volatility subsides and investor confidence returns we look for a large sell off as rates normalize. Bond prices are vulnerable to a pickup in economic activity, a sustained stock market rally or hints of inflation. We have just moved duration from long to neutral. Eventually yields should rise as the slowdown in the economy gives way to strong economic data. Large deficits will also be an eventual problem for bonds. Inflation is currently not an issue, however, if excess liquidity remains in the system as the economy recovers it could become the major issue.