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Government bonds continue to underperform their corporate counterparts, but their downward spiral might be slowing, says a CIBC portfolio manager. 

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As of Aug. 31, Government of Canada bonds have generated negative returns this year, with seven- to 10-year notes returning negative 2.66%, according to FTSE Russell. 

Adam Ditkofsky, portfolio manager and vice-president at CIBC Asset Management, said this can be attributed to higher inflation, which has caused interest rates to rise. 

However, Ditkofsky noted that government bonds performed worst in the first quarter of the year when inflation concerns were at their peak and the vaccine rollout was still in its early stages. In the three months to Aug. 31, the same set of government bonds generated positive returns of 2.20%.

“Over the past three months, government bond yields have actually moved lower as growth expectations have fallen from their peak,” said Ditkofsky in a Sept. 14 interview. The yield on the 10-year Government of Canada bond closed at 1.17% that day, but rose as high as 1.50% this week.

Ditkofsky said returns on provincial bonds have been similar. Year to date, provincial seven- to 10-year bonds were down 1.60% as of Aug. 31, according to FTSE Russell. Over the past three months, those bonds are up 1.92%.

Ditkofsky said he remains underweight in both federal and provincial bonds, relative to benchmarks, and maintains a healthy overweight in corporate bonds, which he expects will continue to outperform government bonds over the next 12 months.

However, he continues to have some exposure to government bonds because of their ability to provide “support in periods when markets become more risk averse.”

Ditkofsky said one exception is Government of Canada agency bonds, where he remains overweight, particularly bonds issued by the Canada Mortgage and Housing Corporation (CMHC) as they offer investors additional spread relative to Government of Canada bonds with only modestly less liquidity.

Looking forward, Ditkofsky said he continues to expect above-trend growth for GDP and inflation, but down from the elevated levels earlier this year. Several institutions have downgraded growth forecasts, with Fitch Ratings recently slashing its Canadian GDP call for 2021 from 6.6% to 5%.

“Ultimately, over time, we should see real GDP growth return to more normalized pre-pandemic levels of sub 2% and inflationary pressures should also come down as transitory supply chain disruptions clear,” he said. 

In addition, Ditkofsky said he doesn’t anticipate the Federal Reserve or the Bank of Canada will raise their policy rate until the second half of 2022, “which should support short-term bond yields staying near current levels for most of the year.”

He also predicts longer-term bond yields moving only modestly higher, capped by slowing inflation and GDP compared to levels experienced earlier this year. 

“Government bonds make up an important part of our portfolio,” Ditkofsky said, “but we continue to believe corporate bonds will outperform as investors benefit from higher yields in the current economic backdrop.”

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.