Bond market turmoil is not a typical feature of Canadian finances, but a revolt seems to have begun there recently. Buried in a 96 page economic update at the end of last year, the Department of Finance of Canada led by Chrystia Freeland killed its inflation-protected bond program — even as the country battles its worst price pressures in 40 years.
Rapidly rising prices and their impact have been the dominant theme in global markets over the past year, highlighting bonds that promise protection against the value-eroding effects of inflation. They pay fixed interest like regular government bonds, but regularly adjust the principal – the lump sum repaid at the end – according to inflation rates.
Ottawa’s decision is therefore a real rebellion in the slow world of bond fashion, where public debt managers generally appreciate gradual and well-signaled moves that do not bother bond buyers. They also tend to watch their peers closely: when one manages to open a market for, say, ultra-long 50-year bonds or finds demand for “green” debt to finance environmentally friendly projects , others follow.
Canada, an early adopter of “real return” bonds in 1991, abandoned its program with immediate effect and is now an exception among G7 countries. Even Japan, still primarily concerned about deflation, is selling some protection.
Ottawa cited weak demand as a factor in its decision and pointed to the results of industry consultations in previous years. Yet the move has drawn howls from pension funds and others who use the products to help deal with liabilities that span decades.
“Bad signal, bad timing,” said the Canadian Bond Investors Association, representing fund managers holding some $900 billion in assets. He call for a thought. “Now more than ever, investors are more interested in inflation protection products.”
Bond investors are powerful players given their financial weight and their role in financing governments. A committee advising the Bank of Canada has also concern expressedsome members feared that this decision would give the impression that the government was concerned that it could not completely contain inflation.
Beyond Freeland’s departmental decision and investor apprehensions, there is an uncomfortable truth about how inflation-linked bonds work.
Take performance. The United States offers the largest inflation-indexed market with its inflation-protected Treasury securities. Investors tracking Bloomberg’s Tips Total Return Index lost nearly 12% last year, while another tracking regular US bonds on the same basis lost 12.5%.
In other words, Tips’ short-term performance fell victim, and almost as badly, to the same factors as their regular cousins, namely the unusually strong series of interest rate hikes by the Federal Reserve. The Fed pushed bond prices down faster than could be countered by soaring inflation pricing.
“Inflation-linked bonds generally performed last year exactly as they should have done given the environment,” says Michael Pond, global head of inflation market research at Barclays. “There was a lot of talk last year about using them as inflation protection, but they only guarantee you that real return if you hold them to maturity. They are not short term protection.
This buy-and-hold logic suits those with long horizons such as pension funds and insurers, but the resulting illiquidity can drive up costs for smaller issuers by widening the gap between price that buyers and sellers will pay.
“Debt management offices are responsible for issuing bonds that minimize expenses. On that basis, inflation-linked bonds are probably not the most effective for smaller borrowers like Canada,” said Darrell Duffie, a Stanford professor and bond market expert.
About 2% of Ottawa’s borrowing was real-return bonds before dropping the program, while Tips account for about 8% of Washington’s issuance.
For example, the U.S. Treasury on Thursday sold $9 billion in 30-year bonds, raking in more in a single trade than Canada from its combined sales of real-return bonds over the past five years.
Despite Ottawa’s revolt against bond market orthodoxy, others are holding the line against inflation. Investors accepted a record 90.1% of the US deal this week, leaving dealers – the banks that trade the bonds – with far fewer bonds than average.
Still, buying inflation protection looks likely to remain a niche market and demand is unlikely to suddenly increase. This may leave Ottawa comfortable in its decision. But with his peers facing far greater early burdens, the rebellion is unlikely to spread.
jennifer.hughes@ft.com