Bond markets look boring on the surface – buy a bond at a price that locks in a guaranteed yield, collect annual payments, get the principal back when the bond matures. Yawn. The simplicity of the bond structure, however, masks a global market of near bottomless complexity. This complexity includes the fact, according to Canadian Imperial Bank of Commerce, that domestic mortgage rates will likely be significantly affected by Japanese life-insurance companies.
In a research report published on Monday, CIBC interest-rate strategist Ian Pollick detailed the sharp drop in foreign buying of Canadian bonds in recent years. International investors purchased domestic bonds at a $150-billion annual pace in late 2017. In the last quarter of 2018, the 12-month trailing total of foreign buying fell to $25-billion.
International investment in Canadian bonds provides two important benefits. Foreign investment pushed bond prices higher and, because bond prices and yields move in opposite directions, this keeps interest rates and borrowing costs for Canadians lower.
Also, the purchase of domestic bonds is done in loonies, so when an international fund buys domestic bonds, they must first exchange their local currency into Canadian dollars to do the trade. This process involves more bidding for loonies in foreign-exchange markets, and supports our currency’s value.
Countries with low bond yields are more likely to buy Canadian bonds. In mid-2017 for instance, domestic 10-year bonds yielding about 1.8 per cent were extremely attractive to Japanese bond investors because the 10-year yield on Japanese government bonds was barely positive, at 0.1 per cent – 10 basis points – at the time.
Foreign investors are happy to accept the higher yields on Canadian bonds, but they don’t want to take the risk of the loonie falling drastically versus the value of their home currency. That would mean the interest payments and principal repayment would be worth less to them. So non-Canadian buyers are likely to hedge the currency risk through derivatives or other means.
Mr. Pollick notes that, globally, the costs of hedging against currency volatility have been rising rapidly. He wrote that a Japanese investor now buying U.S. Treasury bonds – which yield 1.53 per cent compared with the Japanese 10-year that currently yields roughly zero (0.04 per cent) – would receive a return of negative 45 basis points because of currency hedging costs.
For a global investor, the high costs of hedging currencies dramatically reduces the benefit from higher yielding opportunities outside of their country. Mr. Pollick believes this was a major factor behind the decline in international buying of Canadian bonds.
Good news may be on the horizon. Early last week, a handful of Japanese life-insurance companies – traditionally large purchasers of foreign bonds – said they would be increasing their foreign-bond purchases on an unhedged currency basis, according to the CIBC report. The news immediately put a bid into the bond market.
A big jump in foreign buying of Canadian bonds by insurance companies from the other side of the planet would help push the loonie higher and borrowing costs – including mortgage rates – lower.
Bond markets are clearly not boring and the intricacies of foreign-asset flows are only the tip of the iceberg. Mr. Pollick in his report, as another example, recommended a trading strategy I’d never heard of before, a “box trade” with U.S. and Canadian yield curves. Through a combination of long and short positions, the trade would benefit from a flattening of the Canadian yield curve and a steepening of the U.S. yield curve between five-year and 30-year issues.
Bonds themselves may be simple financial assets but bond markets and trading strategies are, to me, endlessly fascinating.
-- Scott Barlow, Globe and Mail market strategist
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Stocks to ponder
Equitable Group Inc. (EQB-T). While Canada’s biggest banks are struggling with slower loan growth, one of the country’s smallest lenders is shaking off the trend – and its share price is rallying. Equitable Group Inc., the country’s ninth-largest bank, is up 24.6 per cent this year, about double the average gain of 12.1 per cent for the Big Six. Yet the stock’s valuation is among the cheapest in the sector, suggesting plenty of potential. David Berman reports (for subscribers).
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The slowing economy is making it more difficult for equity analysts to accurately predict bank profits, suggesting that investors may want to get used to the kind of volatility that follows earnings misses. Last quarter, four of the Big Six banks – Toronto Dominion, Nova Scotia, CIBC and National – fell short of earnings forecasts as higher credit losses stemming from slower growth took a toll on income statements. A contributing factor was new accounting rules that forced banks to disclose expected losses. Tim Shufelt reports (for subscribers).
Inflation is not as dead as it appears
Bloomberg Businessweek magazine’s latest cover asks “Is Inflation Dead?” The article’s conclusion: Yes, probably. Capitalism killed it. With globalization, automation and de-unionization. This is an entirely reasonable position. It does, however, stir memories of that similar cover from 40 years ago that proclaimed “The Death of Equities” just as markets started a long rise. Could inflation, as with the 1970s stock market, just be biding its time? Ian McGugan takes a look (for subscribers).
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Ask Globe Investor
Question: Last year, my Canadian Real Estate Investment Trust (REF-UN) units were acquired by Choice Properties REIT (CHP-UN) for a combination of cash and Choice units. How do I report this on my tax return?
Answer: There are no immediate tax consequences for CREIT units that were exchanged for Choice units, as this portion of the deal was considered a tax-deferred rollover. Basically, the total adjusted cost base (ACB) of the new Choice units received would be the same as the total cost base of the exchanged CREIT units. You would use this ACB figure to calculate your capital gain (or loss) when you ultimately sell the Choice units.
For the cash portion of the transaction, it is more complicated. Each CREIT unit was acquired for $53.75, so your net capital gain per unit will be $53.75 minus your ACB. However, reporting the transaction on your return is a two-step process that requires entering information from a T3 and a T5008 slip. You must complete both steps or you could end up paying more tax than necessary.
The T3 will show a capital gain of $50.60 per CREIT unit (reflecting the sale of CREIT’s properties as part of the transaction). The T5008 will show proceeds of disposition of $3.15 per CREIT unit (representing the cash takeover price of $53.75 per unit less the capital gain of $50.60 already allocated on the T3).
If your ACB was, say, $40, you would report a capital loss on your return of $36.85 ($40 minus $3.15), which would offset the capital gain of $50.60 reported on the T3, for a net capital gain of $13.75. Choice provides a detailed example on its website at choicereit.ca. This is all assuming you held your CREIT units in a non-registered account, of course; in an RRSP or other registered account, there are no tax consequences from the transaction.
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Compiled by Gillian Livingston