By Sandrine Soubeyran, Global Investment Research, FTSE Russell
Canadian corporates succumbed to heightened risk aversion in March, following the banking turmoil, before swift US and Swiss central bank market interventions calmed markets. While Canada IG has shown initial resilience during the financial instability in March, it has underperformed US IG during the recovery. Why?
The extent of the fear of contagion can be seen in the shape of the 10/2s Canadian government yield curve in Chart 1. As Canadian investors reached for the safety of short-dated government bonds, this caused the 10/2s curve to become less inverted as a result, as banking frailties developed. But, although the move in the Canadian yield curve was less pronounced than the US, partly because US banks took centre stage in the crisis, both US and Canadian curves subsequently ‘re-inverted’ to similar, less negative, levels than prior to the banking crisis. Also, it is worth noting that contrary to perception, Canadian government bonds and the yield curve do not always track closely US Treasuries, as illustrated by the differing reactions in March.
Different stages in central bank policy
One explanation for the more modest Canadian curve reaction is the Bank of Canada’s policy pause, whereby a bigger decline occurred in US 1-3-year yields. Unlike the Fed, the BoC has already paused policy and is, therefore, projected to be among the first G7 countries to ease. In the US, Fed futures show approximately 25bp of further tightening in May, before 50bp of easing by end-2023, while the Fed’s dot plots show rates peaking at 5.1% on the median, with no rate cuts until 2024.
Canadian IG yield spreads stay high vs US IG?
Both Canadian and US credit spreads widened during the risk off episode in March and they remain wider than their pre-banking crisis levels. However, as Chart 2 shows, although US and Canadian HY spreads re-tightened markedly after central bank market intervention, Canadian IG spreads narrowed much less.
A closer inspection of the Canadian and US HY and IG spreads in Charts 3 shows US IG spreads re-tightened through early April, while Canadian IG spreads remained flat, as the modest rebound in government bond yields was mostly offset by a rise in Canadian IG corporate yields. This meant Canadian and US corporate spreads decoupled after briefly converging in March (Chart 3A). Chart 3B also shows how much more volatile US sub-IG spreads were during the recovery phase and how much more they tightened compared to Canadian HY spreads.
Another reason for the decoupling of US and Canadian IG spreads can be found in the absolute yields of both Canadian and US IG bonds and their respective benchmark 7–10-year government bond yields.
As Chart 4 shows, during the initial risk-off period in March, Canadian government bond yields fell more than US Treasury yields. But, during the subsequent recovery phase, Canadian 7–10-year government yields remained flat, while Canadian IG yields rose. For the US, both the IG corporate and 7–10-year Treasury yields declined.
Another key factor is that there are industry, duration, and credit quality differences between Canadian and US IG markets. Canadian IG bonds, represented by the FTSE Canada All Corporate Bond Index, and US IG corporates, by the FTSE US Broad-Investment Grade – Corporate Index, are used for the purpose of this analysis.
From Table 1, Canadian IG has a higher Financials weighting than US IG and Chart 5 clearly shows the sharp spike in Canadian spreads during the banking crisis led by Financials (dark blue line), as a result.
Examination of the IG indices, for Canada and the US, also suggests the shorter duration (by about 1.5 years) of the Canadian IG index might explain its underperformance during the recovery phase (Chart 4), when Canadian IG returned 1.3% versus 2.0% (2.6% in LC) by US IG bonds, in Canadian dollar terms. The returns in Table 2 capture both the banking crisis and recovery periods during March.
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