The Canadian bond market showed a rotation toward inflation protection in the fourth quarter, on news about Covid-19 vaccines and forecasts for a strong economic rebound, a report from FTSE Russell Canada said.
After deflation fears during the early Covid-19 shock last year pushed investors into safe havens, flows rotated toward inflation protection later in the year, the index firm’s January fixed income report said.
“Despite the Covid second wave and further lockdowns, Canadian real return bonds outperformed in Q4, as the reflation trade continued, buoyed by U.S. election results and the continuation of Bank of Canada [quantitative easing],” the report said.
Canadian 20-year + real return bonds returned 13% for the year, while long-dated U.S. Treasury inflation-protected securities (TIPS) returned almost 23% in Canadian dollars.
“Speculation that the BoC may adopt a Fed-style 2% average inflation target, after the 2021 inflation target review (due in December), may also explain the rise in longer-term inflation breakevens,” the report said.
The Bank of Canada’s quantitative easing also pushed down yields on corporate credit after a spike early in the pandemic. By the end of the year, spreads were below pre-Covid levels, despite the uncertain economic outlook and surge in Covid-19 infections.
The report warned that “[h]igher default and bad loan risks remain a threat to financial spreads.”
The same was true with U.S. corporates, as the Federal Reserve’s bond purchases kept credit spreads low despite higher corporate debt issuance, the report said, noting that Fed purchases of residential mortgage-backed securities contributed to rising house prices and also increased risk appetite, with investors rotating into higher-yielding assets.