What caused the respective spreads to decouple?
Following the banking crisis in March, Canadian corporations became more risk-averse, but swift market interventions from the US and Swiss central banks quickly stabilized the markets. Despite initially displaying resilience during the financial unrest in March, Canada investment grade bonds have underperformed compared to US investment grade during the recovery phase.
In her article for Global Investment Research for FTSE Russell, Sandrine Soubeyran analyses the possible reasons for this lag, noting that the shape of the contagion concern is depicted by the yield curve for the 10/2s (the difference between the 10-year treasury rate and the 2-year treasury rate) Canadian government bond.
As Canadian investors sought security in short-term government bonds, the yield curve became less inverted, but both the US and Canadian curves re-inverted to similar degrees. It is significant to observe that, as evidenced by the fluctuations in responses in March, Canadian government bonds and the yield curve do not always precisely resemble US Treasuries.
According to Soubeyran, the Bank of Canada's policy delay, during which a greater decrease in US 1-3-year rates took place, may account for the Canadian curve reaction, which was more muted. The BoC, in contrast to the Fed, has ceased policy and is thus expected to be among the first G7 nations to lighten.
Approximately 25 basis points of additional tightening are predicted by Fed futures in the US for May, followed by 50 basis points of easing by the end of 2023, whereas the Fed's dot plots predict a median rate peak of 5.1% and no rate cuts until 2024.
The risk off incident in March caused the credit spreads in both Canada and the US to expand, and they are still higher than they were before to the banking crisis. Although US and Canadian HY extends significantly tightened again following central bank market intervention, Canadian IG spreads shrank far less.
Through the beginning of April, US investment grade re-tightened while Canadian IG spreads were stable. This resulted from an increase in Canadian investment grade corporate rates offsetting a resurgence in government bond yields. In comparison to Canadian high yield spreads, data also demonstrates how much more volatile US sub-investment grade spreads were during the recovery period and how much more they tightened.
Soubeyran also wrote that the absolute yields of both Canadian and US investment grade bonds and their corresponding benchmark 7–10–year government bond rates are what cause the US and Canadian spreads to decouple from one another. Canadian 7-10-year government bond rates were unchanged during the recovery phase, whereas Canadian IG yields increased.
Canadian government bond yields declined more than US Treasury yields during the initial risk-off episode in March. The rates on US IG corporate bonds and 7–10-year Treasury bonds also decreased.
Different industries, durations, and credit quality exist across the US and Canadian investment grade markets. The FTSE Canada All Corporate Bond Index represents Canadian investment grade bonds, whereas the FTSE US Broad-Investment Grade - Corporate Index represents US IG corporates. According to data, Canadian investment grade has a greater financials weighting than US investment grade, which caused Canadian spreads to jump dramatically during the financial crisis.
A comparison of the indexes for Canada and the US reveals that the Canadian investment grade index's poor results during the recovery era, when Canadian IG returned 1.3% vs US IG bonds' returns of 2.0% (2.6% in LC) in Canadian currency terms, may be explained by its shorter tenure (by around 1.5 years). The results displayed reflect both the financial crisis and the post-crisis era in March.
