Long Bonds Beat Treasuries on Inflation Outlook: Canada Credit

Long Bonds Beat Treasuries on Inflation Outlook
The Bank of Canada held its target lending rate at 1 percent in October after three successive increases of a quarter-percentage point beginning June 1. Photographer: Patrick Doyle/Bloomberg

Canadian long-term bond yields are falling to the lowest level in more than four years relative to U.S. Treasuries on speculation that inflation in the world’s 10th-largest economy will remain in check.

Canada’s 30-year bond yields traded 67 basis points below equivalent-maturity Treasuries today, nearing the 75 basis-point spread on April 5, the widest since May 2006. The Bank of Canada kept its target overnight rate at 1 percent and underlined “slightly weaker” second-half domestic economic growth. It predicted in an October report inflation would fall to 2 percent by the end of 2012, from 2.4 percent in October.

Investors should purchase Canadian long bonds versus their U.S. counterparts because fluctuations in the nation’s consumer price index are less volatile than its southern neighbor’s, according to Canadian Imperial Bank of Commerce. The Federal Reserve is also shunning 30-year Treasuries in its $600 billion bond-buying program known as quantitative easing.

“The case for outperformance of 30-year Canadian bonds is a strong one,” Mohammed Ahmed, a rates strategist at CIBC World Markets in Toronto, said. “I expect this to persist.”

One-month historic volatility, which measures the rate of fluctuations of a bond price, was 11 percent yesterday on the 1.25 percent inflation-linked Treasury due in July 2020. That compared with 7.6 percent for the 4.25 percent Canadian inflation-linked bond due December 2021, Bloomberg data showed.

Matching Liabilities

Pension funds and insurance companies are buying longer-term Canadian bonds to match liabilities, and supply is constrained because the federal government is selling fewer bonds as its deficit shrinks, according to John Braive, who oversees about C$42 billion ($41 billion) in fixed-income assets at CIBC Global Asset Management.

The gap between the Canadian 10-year to 30-year yield curve and the equivalent U.S. curve ended yesterday at 84 basis points, which is “near the widest going back to 1970,” Braive said via e-mail.

Elsewhere in credit markets, the extra yield investors demand to own the debt of Canadian corporations rather than the federal government remained yesterday at 143 basis points, or 1.43 percentage points, from Dec. 3, according to a Bank of America Merrill Lynch index. The spread was 142 on Nov. 30. Yields fell to 3.91 percent, from 3.99 percent last week, when they topped 4 percent for the first time since July.

The securities lost 0.85 percent in November as a drop in bond prices drove yields to 3.91 percent on average, from 3.64 percent on Oct. 31. They are down 0.2 percent this month.

Provincial Bond Market

In the provincial bond market, relative yields widened yesterday to 55 basis points. Yields fell to 3.21 percent, from 3.27 percent on Dec. 3. The securities lost 1.2 percent in November, the biggest loss since December 2009, and are down 0.7 percent this month.

New Brunswick sold C$300 million in a reoffering of its 4.5 percent bonds due in June 2020, bringing the total outstanding to C$1.2 billion. Canada’s third-smallest province paid 79 basis points over benchmarks to sell the debt.

The yield on Canada’s 10-year government bonds climbed seven basis points to 3.20 percent, after rising seven basis points last week. The price of the 3.5 percent security due in June 2020 dropped 57 cents to C$102.49.

Canada will auction C$3.2 billion of three-year bonds tomorrow. The securities mature in March 2014. The previous auction of three-year bonds, held on Aug. 4, drew an average yield of 1.891 percent and a bid-to-cover ratio of 2.78 times.

In contrast to the 30-year yields, those of the two-year and 10-year bonds trade higher than their U.S. counterparts, with the spreads over Treasuries ending yesterday at 114 basis points and 20 basis points, respectively.

Provincial Long Bonds

CIBC’s Braive wouldn’t comment on whether he’s buying Canadian 30-year bonds. He said he expects provincial long-bond issuance to be “strong.”

Government bonds had their worst month of the year in November, down 1 percent, compared with a drop of about 0.7 percent for Treasuries. They’re down 0.3 percent in December.

The Bank of Canada held its target lending rate at 1 percent for a second straight meeting, matching the forecast of all 24 economists in a Bloomberg survey. Policy makers said they will remain careful about future increases as falling exports and Europe’s sovereign debt crisis hinder the economic recovery.

Fed Purchases

The Federal Reserve announced $600 billion in bond purchases on Nov. 3 in so-called quantitative easing measures to spur growth and cut unemployment. Canada’s central bank, in contrast, has been easing liquidity as the government predicts a return to budget balance in five years. Canada’s economy has recouped all jobs lost during the recession. The U.S. unemployment rate unexpectedly rose to 9.8 percent last month.

“Quantitative easing in the U.S. brings with it the risk of inflation, and there’s no parallel in Canada,” Eric Lascelles, chief economist and strategist at TD Securities, a unit of Canada’s second-biggest bank, said by phone from Toronto. “Canada’s long-bond market hasn’t suffered the same consequences. It fits into a broader narrative that the structural attractions for Canada are much greater than the U.S. and they apply not just to a lack of quantitative easing, but equally to inflation-fighting credibility.”

‘Explicit’ Policy

Canada maintains an “explicit” inflation-fighting policy, and the U.S. doesn’t, Lascelles said.

The outperformance in Canadian 30-years is more pronounced in the “real,” or nominal side, rather than the inflation-protected notes, he said.

“The gap has opened up in real yields and less so in the inflation part,” Lascelles said. “You fall back on the supply story and just the confidence of being paid back. It’s the fiscal-position story.”

Canadian 30-year breakeven rates, which measure the yield gap between inflation-linked and cash bonds and gauge price expectations, ended yesterday at 2.39 percent, versus 2.54 percent in the U.S.

Canadian real yields -- the yield minus the annual inflation rate -- widened to 1.04 percent at the end of November. U.S. real yields stood at 2.93 percent.

Canada’s government bonds with maturities greater than 15 years have lost 2.3 percent since Nov. 2, the day before the Fed announced quantitative easing, according to a Merrill Lynch index. That’s compares with a 4.4 percent loss posted by an index of 15-year-plus Treasuries.

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