Canada deals hammer blow to inflation hedge tool just as investors need it most

Canada is facing pressure to reverse its decision to end issuing real return bonds, a product pension plans rely on to ensure that inflation, currently at its most volatile in decades, does not erode the assets they set aside to pay benefits to retirees.

In a surprise move, the Canadian government said earlier this month that it had decided to cease issuance of real return bonds (RRBs), citing low demand.

The bonds, which pay a coupon that is linked to the level of the consumer price index, tend to be less liquid than regular bonds, with investors demanding a discount to purchase them.

That makes them an expensive form of financing for the government, but cost should not be the only consideration, investors say.

Indexed pensions pay out benefits to retirees that are linked to inflation. Removing the supply of an inflation-tracking investment opportunity could make it more difficult for those plans to meet their obligations.

“Inflation is high and a lot of plans were thinking about getting more into this asset class, and now the asset class has been removed,” said Ashwin Gopwani, managing director, client solutions at SLC Management, which manages investments for pension plans.

The median allocation by defined benefit pension plans, a major category, to RRBs was 5.2% in 2021, data covering members of the Pension Investment Association of Canada (PIAC) shows.

The association’s board is meeting next week to look at the impact of the government’s move, PIAC said.

The Canadian government said it undertook extensive consultations in 2019 which showed poor demand for RRBs and this was reinforced in recent consultations with market participants.

With roughly C$49 billion ($36.7 billion) of RRBs outstanding, the market is too small for the largest pension funds to adequately hedge their inflation risk.

They have turned to other types of assets, such as real estate and infrastructure projects, but those assets are less suitable for smaller, more mature pension plans.

“It’s a hard bet for midsized plans that are paying out their last members in the next 10 or 20 years. They may not have the time frame to earn those returns and hope that they keep up with inflation,” Gopwani said.

Canada’s annual inflation rate held steady at 6.9% in October. It is not expected to return to the Bank of Canada’s 2% target until the end of 2024, the central bank said last month.

In a letter this week, the Canadian Bond Investors’ Association (CBIA), which represents investors that manage over C$1.2 trillion in fixed income assets, urged the government to reverse its decision, saying there is a strong and “possibly growing demand” for RRBs in the current inflationary environment.

Investors will still be able to hedge in the outstanding stock of RRBs but say that the market has already become less liquid and the bonds could become scarce.

U.S. Treasury Inflation-Protected Securities (TIPS) could act as a proxy but are not an exact hedge against Canadian inflation.

Adding to the consternation of investors is the likely disruption to the measure of inflation expectations that the RRB market captures through its breakeven rates. Breakeven rates are the difference between yields on nominal and real return bonds.

“RRBs must be given a chance to prove their worth in a world of elevated uncertainty around Canada’s economy, inflation and public finances,” strategists at National Bank of Canada, including Warren Lovely, said in a note.

($1 = 1.3350 Canadian dollars)

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