While Canadian government bond yields have decoupled from U.S. Treasuries in the past year, with the spread widening in October, the two are still “tightly correlated,” Robin Marshall, FTSE Russell’s director of global investment research, said during a November webinar.
In Canadian corporate credit, investment-grade bond spreads have tightened, with triple- and double-A bonds converging with single-A bonds. The drop in spreads is present in all corporate sectors, especially infrastructure.
In October, the Bank of Canada predicted GDP growth of 1.2% this year and 0.9% in 2024 amid a difficult macroeconomic environment. Canadian wage inflation is between 4% and 5%, and early signs of a cooling job market are shown in an unemployment rate approaching 6%. The Bank of Canada has paused rate hikes over worries of cost-push inflation.
“Market expectations on rates oscillated widely in 2023,” Marshall said. “But there’s now little easing projected until 2024 because of the difficulty in squeezing that last bit of inflation out before getting down to the 2% target.”
The challenging economic outlook and higher-for-longer rates mean it’s time for investors to reconsider their fixed-income strategy.
“If we have left the zero-rate era, which seems likely for now,” Marshall said, “the implications could be profound for asset classes like fixed income.”
For the year to Oct. 31, Canadian high-yield corporate bonds saw 3.5% returns compared with 1.2% returns for investment-grade bonds, while U.S. high-yield saw 6.7% returns compared with 0.6% returns for investment-grade.
Higher coupons helped with positive returns, and “this may be a new normal where coupons now drive more of the returns,” said Sandrine Soubeyran, FTSE Russell’s director of global investment research, during the webinar.
Over the past year, U.S. high-yield corporate bond yields rose more sharply than those of their Canadian counterparts after U.S. Treasury yields surged on higher-for-longer rates, reduced risk appetite and strong third-quarter U.S. economic growth, Soubeyran said. This continued the trend of Canadian high-yield spreads being more stable than U.S. high-yield spreads since 2021.
Provincial and municipal bonds have mirrored federal yields since 2018. However, spreads fell in October for Alberta and B.C., which have budget surpluses. Over the past few months, long-term municipal bond spreads have increased with higher-for-longer rates while mid-term muni spreads remained stable. Short-term muni spreads lowered in October as Canadian economic activity slowed.