Marquest Fixed Income Market Commentary

Rising liquidity, low rates continue to support a growing economy.

1. The global bond market – nominal yields falling but real yields are negative in Canada
2. Supply and demand in the debt capital markets
3. Liquidity continuing to support falling risk premiums in credit markets

Declining yields a global story
With a number of signs of weak economic growth in North America and other major regions, bonds have been performing well. In May, Canada’s 10 year yields fell 22 basis points, hitting 3.07% at month end. Those in the U.S. fell 27 basis points over the month as well. Barring the outlier countries that carry sovereign credit risk, this pattern is consistent in government debt markets globally. Yields on UK’s 10 year gilts fell 14 basis points, those on Germany’s 10 year bunds fell 20 basis points, Australia’s equivalent yields also fell 22 basis points. In contrast, those in Greece rose almost 1% last month to over 16% as the risk that the country may need greater financial support (€110 billion was allocated in May last year) have continued to worsen.

Economically, Canada continues to stand out relative to most of the OECD. Where other economies are experiencing a slowdown, Canada has continued its positive, though tepid, growth path. Our housing market is operating normally as building permits and prices are both displaying positive growth. The labour market has been recovering from the 2008/09 recession as unemployment fell to 7.6% last month. Retail sales ex-autos have been positive on average as have manufacturing sales.

The next source of concern in a growing economy with low market yields is inflation. Given the tepid nature of the growth we’ve had it does not appear to be a great risk. However, without bond managers paying attention to it inflation, at 3.3% in April, has risen above nominal yields even in the 10 year sector where long term borrowing occurs and we now have a negative real yield environment. The bond market hasn’t really come to grips with this. Expectations for inflation priced into real rate bonds remain below 2.5%, as illustrated in Chart 1, below.

Supply and demand in debt markets
A key piece of the recovery story is the return of lenders back into the capital markets. In Chart 2 below we highlight 2 indicators of liquidity in basic bank lending activity:

1. Lending standards at the major banks. Each quarter, the Federal Reserve in the U.S. carries out a survey of 60 large domestic banks and 24 branches and agencies of foreign banks, questioning changes in standards and terms of bank lending. The results are published on their website and we see it as an indicator of the availability of credit for corporate borrowers.
2. Growth in commercial and industrial loan volumes. The U.S. Federal Reserve also monitors actual lending activity. For comparison with the survey above we’ve calculated the percentage change on a quarter over quarter basis.

According to the Federal Reserve, lending standards at the major banks have loosened up considerably over the last year. With a slight lag, the volume of loans to commercial and industrial borrowers has also been rising. We see this as being very important for continuation of the economic recovery in North America.

Credit spreads have found a floor
With this growth in overall activity we also see lenders becoming more comfortable with recent declines in the risk premium charged for credit. Chart 3 presents credit spreads for corporate debt – they are low, but remain above the levels seen in 2004 through 2007 when the debt markets became very complacent about leverage levels in the economy.

It should be noted that credit spreads have become comfortable with the current low levels as they’ve been in this area for several months. This is also close to the lows seen in the second quarter of 2010. The implication is that a general decline in credit spreads is not a high probability so security selection and a strong investment management platform will be the drivers of performance going forward.

We should also note that if we move into a rising yield environment, enhancing returns requires investing in securities with income that grows with market rates, otherwise known as floating rate debt. Examples of these are T-Bills, asset-backed and some commercial debt instruments, as well as senior or leveraged loan portfolios. Recent demand for floating rate debt in structured products in Canada has been strong. Marquest has been increasing the allocation to floating rate strategies as market yields have fallen to levels we consider unsustainable.

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