2018 started with confidence from the Bank of Canada’s (“BOC”) economic outlook for the year. However, the GDP growth forecast gradually declined as oil prices dropped and as tensions grew in international trade markets. As a result, we saw a reversal in the increasing trend of Government of Canada (“GOC”) bond yields at the end of 2018. 2019 begins with some uncertainty around the growth in the Canadian economy, the direction of GOC yields, and whether further increases in the overnight rate will occur in 2019.
GOC bond yields ended generally flat in 2018 – the 3-year GOCincreased by 11 bps, 5-year increased by 1 bps, and the 10-year GOC yield decreased by 9 bps.
There were three rate hikes in 2018 for the Bank of Canada (“BOC”) overnight target rate, which brought the rate to 1.75%,
the highest since Q4/08, but the Bank of Canada held the overnight rate constant for their last two meetings.
Capital supply and competition for commercial mortgages remained strong throughout 2018 as spreads continued to absorb the increases in the GOC yields, holding commercial mortgage coupons relatively steady. During Q4/18, GOC bond yields fell in response to the deteriorating outlook from the BOC, reversing the upward trend in 2018. Corporate bond markets reacted as
investors demanded higher spreads – roughly 50 bps higher for
BBB-rated corporate bonds in Q4/18 alone. Commercial mortgage spreads became a hot topic towards the end of Q4, as brokers and investors alike were looking for signs of change in the market. Commercial mortgage spreads eventually reacted with an increase in December by 10-15 bps, ending the year at 150-170 bps for top quality assets. The average 5-year conventional commercial mortgage coupon ended 2018 roughly flat at 3.60%. January 2019 has quickly seen another 15 bps increase in spreads, now in the range of 165-185 bps for top quality assets.
BBB-rated corporate bond investments tend to compete for the same capital as commercial mortgages, since BBB-rated corporate bonds provide a similar return on risk. As firms look to make portfolio investment decisions, the spread premium for commercial mortgages over BBB-rated corporate bonds can be an indication of where capital supply may shift or how commercial mortgage spreads may respond to changes in BBB-rated corporate spreads.
Recent increases in BBB-rated corporate bond spreads improved the relative attractiveness of this investment against commercial mortgages. The spread premium for commercial mortgages dropped from 85 to 25 bps year over year – significantly lower relative to the 67 bps long term average. Consequently, commercial mortgage funds may require higher spreads to compete for capital against their BBB-rated corporate bond counterparts.
Based on the low spread premium for commercial mortgages compared to the long-term average, a further widening in commercial mortgage spreads is possible.