Canadian government bonds are overvalued and no longer provide any margin of safety. The formula to value a bond is as follows. You add the real yield to expected inflation to get the real adjusted fair value. If the bond you are valuing, offers a yield less than this this formula, you are overpaying. For example, the current real yield according to 10 year Canada real return bonds is about 1%. The expected inflation according to Bank of Canada’s governor Mark Carney is 3%. Therefore, the fair value yield on a 10 year government of Canada bond should be 4%. However, 10 year Canada bonds are offering a yield of around 3% today. Which means this bond is overvalued by 1%. As a value investor, we always want to have a margin of safety when buying an asset to prevent us from overpaying. A value investor analyzing a 10 year Canada bond would probably want to receive a yield of at least 5% to compensate for the risks.
In our minds, government bonds in both Canada and the U.S. are grossly overvalued and at some point, interest rates will rise taking bond prices down at a dramatic pace. As a result, we have reduced our bond weightings and kept our existing bond maturities very short.
