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Inflation-linked bonds disappoint even as they deliver on their promise

Bond market upsets aren’t a typical feature of Canadian finances, but one revolt appears to have begun there recently. Buried in a 96-page economic update late last year, Canada’s finance ministry led by Chrystia Freeland killed off its inflation-protected bond issuance programme — even as the country battles its worst price pressures for 40 years.

Fast-rising prices and their impact have been the dominant theme across world markets in the past year, putting a spotlight on bonds that promise protection against inflation’s value-eroding effects. They pay out fixed interest like regular government bonds but regularly adjust the principal — the lump sum repaid at the end — in line with inflation rates.

Ottawa’s decision is thus a real rebellion in the slow-moving world of bond fashions, where government debt managers usually prize gradual, well-signalled moves that don’t upset bond buyers. They also tend to watch their peers closely: when one succeeds in opening a market for, say, ultra-long 50-year bonds or finds demand for “green” debt to fund environmentally friendly projects, others follow.

Canada, an early adopter of “real return” bonds in 1991, has dropped its programme with immediate effect, and is now an exception among G7 nations. Even Japan, still mostly concerned about deflation, sells some protection.

Ottawa cited low demand as a factor in its decision and pointed to the results of industry consultations in earlier years. Still, the move has prompted howls from pension funds and others who use the products to help meet liabilities stretching out over decades.

“Wrong signal, bad timing,” said the Canadian Bond Investors’ Association, representing fund managers holding some $900bn in assets. It called for a rethink. “Now more than ever investors have greater interest in inflation-protection products.”

Bond investors are powerful players given their financial heft and role in financing governments. A committee advising the Bank of Canada also voiced disquiet, with some members fretting that the move might create a perception that the government feared it could not fully contain inflation.

Beyond the decision by Freeland’s ministry and investor misgivings, there’s an uncomfortable truth about how about inflation-linked bonds work.

Take performance. The US offers the largest inflation-linked market with its Treasury inflation-protected securities. Investors tracking Bloomberg’s total return Tips index lost almost 12 per cent last year, while one following regular US bonds on the same basis lost 12.5 per cent.

In other words, Tips’ short-term performance fell victim, and almost as badly, to the same factors as their regular cousins — namely, the Federal Reserve’s unusually sharp series of interest rate rises. The Fed pushed bond prices down faster than could be countered by pricing in rocketing inflation.

“Inflation-linked bonds generally performed last year exactly how they should have done given the environment,” says Michael Pond, global head of inflation market research at Barclays. “There’s been a lot said in the last year about using them as protection against inflation but they only guarantee you that real return if you hold them to maturity. They’re not protection over short-term horizons.” 

That buy-and-hold rationale suits those with distant horizons such as pension funds and insurers, but the resulting lack of liquidity can push up the costs for smaller issuers by widening the gap between the prices buyers and sellers will pay.

“Debt management offices are charged with issuing bonds that minimise expense. Inflation-linked bonds probably aren’t the most efficient for smaller borrowers like Canada on that basis,” said Darrell Duffie, Stanford professor and bond markets specialist.

Around 2 per cent of Ottawa’s borrowing was in real return bonds before it dropped the programme, while Tips account for roughly 8 per cent of Washington’s issuance.

For example, the US Treasury on Thursday sold $9bn in 30-year Tips, garnering more in one deal than Canada did from its combined sales of real return bonds for the past five years.

Despite Ottawa’s revolt against bond market orthodoxy, others are holding the inflation-protected line. Investors took up a record 90.1 per cent of this week’s US deal, leaving dealers — banks which trade in the bonds — with far fewer bonds than average.

Still, buying inflation protection seems likely to remain somewhat of a niche market and demand is unlikely to spike suddenly. That may leave Ottawa comfortable in its decision. But with its peers facing far larger debut burdens, the rebellion is unlikely to spread.

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