Costly `Wallpaper' Bonds Misjudge Interest-Rate Increases: Canada Credit

Investors who bought C$3 billion ($2.87 billion) worth of Canadian two-year bonds this week overpaid because the Bank of Canada may raise interest rates faster than is reflected in the yield.

“Lots of expensive wallpaper was sold” at the June 2 auction, said Derek Holt, an economist with Scotia Capital in Toronto, in a note to clients yesterday. “The overnight rate is going up in such a manner as to leave you exceptionally under- compensated.”

The 2 percent bond maturing September 2012 sold for C$100.16 to yield 1.93 percent, which declined to 1.91 percent yesterday. The auction attracted bids worth 2.4 times the amount sold, a drop from the 2.54 ratio at the May 5 auction of the current two-year benchmark that matures June 2012.

The Bank of Canada on June 1 raised its key policy interest rate to 0.5 percent from a record-low of 0.25 percent and signaled further increases may be delayed by slower domestic and global growth. The Canadian dollar fell 1 percent and the yield on the current two-year benchmark bond fell 11 basis points to 1.71 percent following the announcement.

The central bank wanted “to keep markets guessing so they don’t prematurely tighten ahead of when the Bank of Canada is prepared to do so itself,” Holt said. By doing so, the bank is preventing the market from withdrawing monetary stimulus ahead of its own schedule, he said.

Elsewhere in credit markets, Quebec, Canada’s second most- populous province, sold C$500 million in a reoffering of its 4.5 percent securities maturing in December 2020. The bonds priced to yield 81 basis points over the 10-year Government of Canada benchmark. National Bank Financial led the sale.

General Electric Bonds

General Electric Capital Canada sold C$500 million in 4.24 percent notes maturing in June 2015, priced to yield 155.5 basis points over government debt. First Capital Realty Inc. raised C$125 million in 5.7 percent bonds due November 2017.

Holt predicts the two-year yield will rise to 3 percent by the middle of next year, which would lead to a 1.3 percent drop in the price, according to data compiled by Bloomberg.

“At these levels I wouldn’t be buying the 2-year,” Ric Palombi, a Calgary-based fixed-income fund manager at McLean & Partners Wealth Management Inc., said in a phone interview. “There’s easier ways to make money.”

“We’ve been avoiding that area ever since the fourth quarter of last year because we were anticipating the Bank of Canada moving,” said Palombi, whose firm manages about C$1.1 billion.

Bank Auction

Canada will auction C$3.5 billion of 5-year bonds on June 9, according to a statement yesterday on the Bank of Canada’s website. The 3 percent securities mature in December 2015.

The extra yield investors demand to own Canadian corporate rather than federal government debt ended yesterday at 149 basis points, from 150 basis points the day before, according to a Bank of America Merrill Lynch Index. The so-called spread has been as tight this year as 114 basis points on March 19 and widened to as much as 152 basis points on May 26. Overall yields fell to 4.223 percent from 4.231 percent the day before.

Two-year bonds “are looking rich, because the market is doubting that the Bank of Canada will go ahead with the next few rate hikes,” said Avery Shenfeld, chief economist with CIBC World Markets in Toronto. “In all likelihood, they’re going to continue with quarter-point hikes at each of the next few meetings, and as that gets priced in, the market is likely to take two-year yields significantly higher.”

Canada, which had its fastest growth in a decade during the first quarter, today reported a better-than-expected 24,700 jobs gain for May. Economists forecast a gain of 15,000 jobs, which would have been the smallest since December.

The yield on the benchmark 1.5 percent bond maturing June 2012 fell 14 basis points to 1.63 percent as of 2:47 p.m., after reaching 2.19 percent on April 21.

To contact the reporters on this story: Alexandre Deslongchamps in Ottawa at adeslongcham@bloomberg.net; Chris Fournier in Montreal at cfournier3@bloomberg.net.

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