us-canada-puzzle

With another Olympics having come and gone, Canada proved yet again it could compete on the world stage by placing 13th in total medal count. And at the ongoing Paralympics, Canada is also currently in 13th place.

But the Olympics and Paralympics aren’t the only areas we’ve received gold medals.

Canada is attracting record foreign bond market investment, according to IFIC. As a result,  we are one of only four countries in the world with a golden triple-A debt rating (Germany, Switzerland, and Sweden are also top rated, according to S&P).

Read: Wealthy immigrants choose Canada

Several factors have contributed to this:

  • Emerging market growth has helped our commodity-driven economy resulting in tremendous wealth creation and a strong housing market.
  • Foreigners view our federal majority government as stable (especially compared to Europe and the U.S.’s current political dislocation).
  • We have a more fiscally conservative government focused on managing Canada’s finances versus other developed countries.

So, has Canada secured its top spot for good?

Unfortunately not. Canada isn’t absolved from the debt challenges that many of the world’s developed nations continue to face. Some of our major issues today are similar in nature to that of the U.S. only seven years earlier.

Consumer debt is at 155% of disposable income. Housing and the Canadian dollar remain overvalued. The unemployment rate is only 1.1% lower than the U.S., and we have a budget susceptible to weakening commodity prices.

Add to this slowing emerging market economies, including China’s corporate sector’s razor-thin profit margins and poor banking, lending, and governance standards.

Read: Where to find global growth

And now Quebec’s separatists are re-awakening with another provincial election and the possibility of putting the referendum vote back on the table, which could prove unsettling for our federal and provincial bond market.

So, Canada’s less stable than what most may believe.

If there’s one warning the Canadian government and consumers alike can heed in this deleveraging cycle, it’s that a good defense can also be a good offense.

As a result of low yields, benign inflation, and an overvalued Canadian dollar, current conditions involving a slow growth world are conducive to more defensive risk-reward opportunities.

Each of the following asset classes offers solid downside protection with favourable upside potential:

1)   Canadian investment grade corporate bonds yields offer 2X (approximately 3.5%) the core rate of inflation. Corporations have been more prudent since the crisis. As a result, balance sheets are healthier, better protected from an economic jolt, and have better defensive characteristics to corporate bonds.

2)   U.S. dollar denominated high-yield bonds have yield-to-maturities almost 3X (approximately 6%) the rate of inflation. They also offer downside protection for Canadian investors if priced, bought, and held in U.S. dollars. If global markets were to sell off again, high-yield bonds would sell off as well. However, if held in U.S. dollars, the value of the Greenback could offset the decline in value of the bonds (similar to what happened in 2008 when the Canadian dollar fell from par to 79 cents U.S.).

3)   U.S. mortgage-backed and agency-debt securities implicitly guaranteed by the U.S. government have downside protection because they’re traded in U.S. dollars. Like the Canadian income trust model that was changed by the federal government in 2006, some of these U.S. mortgage REIT investments have current yields in the 12% to 14% range. But they involve a certain amount of leverage and are highly sensitive to interest rate hikes. That being said, with the U.S. pledging to keep rates ultra-low until late 2014, there remains a window before investors need to worry about interest rate hikes that could negatively affect this asset class.

4)   Canadian and U.S. denominated defensive dividend-paying stocks with yields in the 4%-to-6% range continue to offer lower volatility, lower beta, and better income generation. Although many concerns remain about the stock market, valuations based on price-to-earnings and dividend yield differentials (versus bonds) continue to be 20% below historical measures.

Read: Is the bond bull market going bust?

Justin G. Charbonneau, CFA, DMS, FCSI is vice president and lead portfolio manager of  Global Asset Allocation, Fixed Income, & Matco’s  Balanced Fund at Matco Financial Inc. based in Calgary. Matco Financial offers competitive priced, low volatility, income focused Mutual Funds. | @iHelpInvestCFA
Originally published on Advisor.ca

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