Market review
The rapid movement in interest rates that we saw in the first quarter of 2021 gave way to a more measured pace in the second quarter. The Canadian yield curve retraced some of its first quarter changes as it flattened in the second quarter, with short yields moving higher and long yields falling. Ten-year bonds were the strongest performer, moving almost 17 basis points lower on the quarter.
The move in Canadian yields paled in comparison to the change in the U.S., where the yield curve also flattened with 30-year yields moving 31 basis points (Bps) lower. The Bank of Canada (BoC) balance sheet peaked at just under $575 billion at the end of the first quarter. Since then, the BoC has curtailed quantitative easing programs which may no longer be necessary to support provincial and corporate bond markets, leaving total assets now closer to $474 billion. The BoC left rates on hold at their two meetings in the second quarter. And we did see some stagnation in employment growth as the Canadian economy continues to emerge from the most recent virus-related lock downs.
While Canadian credit spreads remained relatively stable throughout the second quarter, the market managed to absorb a significant amount of corporate new issuance. June was one of the highest volume months ever recorded for corporate bond issuance in Canadian history and, after starting 2021 on a slower pace than 2020, closed off a quarter of strong issuance.
While June saw a strong push on supply, both April and May were below 2020 issuance levels. Overall, 2021 first-half issuance marginally trailed 2020 levels, but is still about 33% above the supply average for the previous four years. Thus far in 2021, new corporate issuance in the 10-year and longer-term corporate market has been about 20% of total issuance, which trails the 25-30% average over the previous four years.
Despite the lack of issuance, long Canadian corporate bonds struggled for performance as the Bloomberg Barclays Long Canadian Corporate Index moved two basis points tighter in the second quarter compared to eight basis points tighter for the comparable U.S. index. The financials sector led the long-term corporate spreads tighter, but the sector still underperformed long-term provincials in the second quarter, which moved seven basis points tighter.
While year-to-date provincial issuance was almost 20% below 2020, the supply tap still feels like it has been left wide open for new provincial issuance. In addition, provincial credit ratings have generally trended lower over the quarter with British Columbia, Alberta and Saskatchewan seeing downgrades. Overall, the long Canadian credit market has underperformed both the U.S. and European credit markets since the initial pandemic sell-off.
Some interesting trends to note in the public corporate bond markets include the increasing prevalence of BBB and lower-grade-rated issuers in new corporate issuance. As well there was an increasing number of international corporate issuers issuing Canadian dollar debt. And there was the emergence of multi tranche corporate bond new issuance. We continue to see bank and insurance company issuance of limited recourse capital notes and the related redemption of preferred shares due to lower funding costs. ESG corporate bond issuance continues to grow and evolve and the second quarter saw the first issuance of a sustainability-linked bond from Telus. By the terms of issue, Telus will pay an additional 1% above its regular coupon in the final year before maturity, if the company fails to achieve its sustainability performance targets.
Portfolio review
Strong active returns this quarter were driven by the Fund’s credit choices through positive contributions from sector allocation and security selection. Canadian corporate bond spreads were mostly range bound in the quarter. After a slow April and May, Canadian corporate issuance in June was one of the highest on record. The additional corporate bond supply at the end of the quarter resulted in Canadian spreads underperforming the U.S., with the Bloomberg Barclays Canadian Corporate Index tightening four basis points versus 10 basis points for the comparable U.S. index. The portfolio’s U.S. credit active positions outperformed on the credit outperformance while the Fund also benefitted from positive mark-to-market on its U.S. dollar hedges. This, as long Canadian swap spreads compressed 17 basis points versus only 11 basis points on tightening in comparable U.S. swap spreads.
Duration positioning remained shorter than that of the benchmark throughout the quarter, but negative active returns from duration were more than offset by positive active returns from curve positioning. Inflation expectations moved marginally lower over the quarter, but the Fund’s real return bond holdings outperformed on higher realized consumer price inflation during the quarter.
Portfolio positioning
The portfolio weighting in federal bonds was reduced and allocated to provincial and corporate bonds. The corporate bond weighting to Canadian dollar communication issuers was increased. As well, U.S. dollar issuers were also added, including Amazon and BNP Paribas. To take advantage of the steeper Canadian yield curve, the Fund added to its long provincial holdings.
The excess yield over the benchmark increased as the Federal weight was reduced in favor of provincial and corporate bonds. Duration remained slightly shorter than the benchmark as inflation remains a concern. Credit quality continues to be in line with the benchmark.
The portfolio reduced its overweight to the middle of the yield curve as the yield curve steepened. The portfolio sold 10-year bonds, the strongest performer this quarter, in favor of 20-year bonds to take advantage of higher yields further out the curve.
The credit quality of the overall portfolio was relatively unchanged from the previous quarter. The Fund’s overweight in AAA rated debt was reduced as it sold Canada bonds to increase its AA provincial bond holdings.
The portfolio sold some U.S. dollar corporate bonds this quarter, reinvesting into U.S. treasuries to take advantage of the value-add from its hedges. The portfolio continues to be overweight U.S. dollar corporate bonds, which are excluded from the benchmark. This overweight is driven by the potential for yield enhancement in addition to diversification benefits. The portfolio hedges its U.S. dollar bonds using a cash flow swap to minimize the fund’s exposure to changes in U.S. currency and U.S. interest rates. The U.S. dollar weight of the portfolio increased slightly from 16.4% to 20.4% as SLC found opportunities in selected U.S. corporate issuers.
The portfolio’s overall credit quality was in line with its benchmark. Much of the portfolio’s increase in credit quality in the fourth quarter was driven by a decrease in the corporate bond weighting in favour of federal bonds.
The portfolio is overweight U.S. dollar corporate bonds, which are excluded from the benchmark. This overweight was driven by the potential for yield enhancement in addition to diversification benefits. The portfolio hedges its U.S. dollar bonds using a cash-flow swap to minimize the fund's exposure to changes in U.S. currency and U.S. interest rates. The U.S. dollar weighting in the portfolio decreased by 4.5% to end the fourth quarter at 12.4%. Much of the decrease came from selling U.S. dollar industrial corporate bonds and U.S. treasury bonds to purchase Canadian federals.
