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Research Department

The Bank of Canada and the Financial System

December 18, 2015 - 0 comments

This week, the Bank of Canada published its semi-annual Financial System Review. This report, which highlights the key risks to our country’s financial stability, is a goldmine of information for investors.

The following are the three main takeaways from the report:

1. The most important risk to financial stability is a severe recession.

The risk of a Canadian recession, possibly driven by a high level of consumer debt and low resource prices, is a great argument in favour of global diversification. In the face of an uncertain future, a global portfolio will perform much more consistently than an exclusively Canadian one, because it is less dependent on a few sectors or a particular population.

2. Bond markets have become less liquid because of the post-2008 re-regulation.

A lot of market participants believe the new bank regulations have had the negative side effect of increasing the liquidity risk in the bond market, as bank-owned investment dealers are not authorized to bear as much bond inventory risk as before. In response to this new risk, investors must stay true to their identity. For instance, long-term investors will be much less prone to join low-liquidity events, such as panic selling or buying, thereby avoiding this unnecessary liquidity risk.

3. Credit spreads have widened significantly.

Corporate bond credit spreads widened markedly in 2015. However, many corporate bond ETFs have been resilient in this environment, posting slightly positive returns. Once again, diversification has helped to stabilize returns. Smart investors want to avoid the large losses that can result from holding a concentration in the wrong bond, especially in this type of environment.

The financial markets are as unpredictable as ever, and changes in regulations and market structure (such as the emergence of alternative exchanges) have nurtured the creation of new risks. In such an environment, the portfolio of 20 to 30 actively traded securities that is held by many Canadians will not be able to deliver consistent returns. In contrast, investing for the long run, with an extremely diversified portfolio of global securities, will iron out a lot of the ups and downs of individual securities and deliver a more consistent return.    

By: Raymond Kerzérho with 0 comments.
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