Canada has crippled a timely inflation hedge tool

Government of Canada decides to stop issuing real return bonds despite investors' need

Canada has crippled a timely inflation hedge tool

With inflation presently at its most unpredictable level in decades, Canada is under pressure to reconsider its decision to stop issuing real return bonds, a product that pension plans rely on to protect the funds they set aside to provide payments to retirees.

Earlier this month, the Canadian government unexpectedly declared it would stop issuing (RRBs), citing poor demand.

According to Reuters, RRBs are a costly source of funding for the government, as their lower liquidity compared to regular bonds means investors want to buy them at a discount. But investors argue that price should not be the main factor.

Retirement benefits from indexed pensions are indexed for inflation. It can become more challenging for such plans to fulfill their commitments if an inflation-tracking investment opportunity is removed from their toolbox.

"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," Ashwin Gopwani told Reuters. Gopwani is managing director, client solutions at SLC Management, which manages investments for pension plans.

According to data pertaining to the members of the Pension Investment Association of Canada (PIAC), defined benefit pension plans, a significant group, allocated a median amount of 5.2% to RRBs in 2021.

The Canadian government said in an email to Reuters that it conducted extensive discussions in 2019 that revealed little demand for RRBs, which was confirmed in more recent talks with market parties.

The market is too tiny for the biggest pension funds to fully hedge their inflation risk given the roughly $49 billion (US$36.7 billion) of outstanding RRBs.

Other asset classes, including real estate and infrastructure projects, have become their go-to choice, although they are less suited to smaller, more established pension plans.

The annual inflation rate in Canada remained constant in October at 6.9%, and is not anticipated to return to the Bank of Canada's target rate of 2% until.

In a letter addressed to the government, the Canadian Bond Investors’ Association (CBIA), whose membership represents over $1.2 trillion in fixed income assets, cited a strong and “possibly growing demand” for RRBs as it urged the government to reconsider its decision.

The potential disruption to the inflation expectations indicator that the RRB market measures through its breakeven rates – the difference between yields on nominal and real return bonds – adds to investors' anxiety.

"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.