Canada brings the curtain down on real return bonds

The phasing out of inflation-protected bonds ushers in a new era for inflation hedging in Canada. Where does all this leave asset owners? Now that new issuances of real return bonds (RRBs) are off the table, what tools do investors have in their arsenal to lead the fight against inflation?

When Canadian policymakers announced they were ceasing RRB issuances late last year, market participants were surely baffled by the timing of the decision. The idea of having one less tool to hedge against price pressures—at a time of rampant inflation—incited a wave of pushback from investors, especially pension fund sponsors with indexed schemes. 

The ramifications of Canada’s decision 

While policymakers’ decision to stop issuing new RRBs in Canada was attributed to weak demand, pension fund sponsors and insurers are adamant about the role inflation-linked bonds play in helping them meet their long-term commitments. Future payments to pensioners and beneficiaries are in many ways dependent on indexing, and RRBs have long been the preferred instrument to ensure these liabilities are aligned with interest-rate and inflation changes.

The cessation of the RRB program comes at a moment in which inflation is still a major headwind for investors. Despite having a firmer grip on price pressures, it’s too early for Canadians to declare victory of any kind against inflation. Volatile Consumer Price Index (CPI) components such as food and energy could drive prices higher at any given moment. Add to this the potential of further geopolitical escalation in Eastern Europe, and the question marks surrounding Canada’s decision become even more apparent.

While inflation has come down, it still remains stubbornly high

Tracking headline and core CPI in Canada over the last 5 years

Line chart depicting the progression of headline and core inflation over the last 5 years. After peaking in 2022, both headline and core CPI have come down.

Source: Statistics Canada, as of May 18, 2023.

Still, decision makers at the government level insist they’ve done their due diligence. After conducting 25 meetings with market participants, “ promoting liquidity” and “consolidating funding within core sectors” were cited as the primary catalysts affecting their decision (although a redistribution of RRB issuance volume would have a limited impact on nominal bonds’ liquidity). Understandably, inflation-linked bonds have become a costly borrowing alternative for the federal government. Apart from the illiquidity premium demanded by market participants to invest in RRBs, hefty inflation adjustments have made it harder for policymakers to service RRB commitments amid the current inflationary backdrop—rendering this instrument much less affordable for the federal government compared with nominal financing alternatives. 

The size of the RRB market in Canada

Since their inception in Canada nearly three decades ago, RRBs have become a viable inflation hedging tool for investors. Between 1998 and 2020, the RRB market has trended upward, peaking at CAD$93 billion (up from $10 billion), but given the increase in rates, the market value has dropped in the years preceding the Government of Canada announcement. 

The RRB market has altered its course

Tracking the market value of RRBs over the last 25 years

Line chart depicting the growth of the Canadian RRB market over the last 25 years

Source: Bloomberg, as of April 28, 2023. 

Regarding the dissemination of RRBs in Canada, annual issuances had been almost steady at $2.2 billion until it was reduced in 2020. But even if RRBs represent just a mere fraction of the Canadian government bond market, it doesn’t mean they aren’t relied on by an exclusive cohort of institutional investors.

Canada has scaled back on RRBs since 2019

Annual RRB issuances since 2014 (CAD, billions)

Bar chart depicting annual issuances of RRBs in Canada since 2008.

Source: Bloomberg, as of April 28, 2023. 

This brings us to our next point: What does this mean for asset owners?Canada’s decision to abandon RRB issuance makes it the first nation in the G7 to take inflation-linked bonds off the table.

In comparison with other countries, the percentage of Canada’s local currency government debt that’s inflation linked (9%) is somewhat aligned with the United States (12%) but much less aligned with countries such as the United Kingdom (41%) and Sweden (46%). With no new issuances to offset maturing RRBs in the future, it’s just a matter of time before that position of 9% begins to fizzle out. While it will still be possible to trade RRBs in Canada, price discovery may become a challenge as dealers increasingly revert to acting as agents between market players (instead of providing liquidity from their balance sheets).

"Canada’s decision to abandon RRB issuance makes it the first nation in the G7 to take inflation-linked bonds off the table."
It's only a matter of time before Canada's RRB position begins to fizzle out

Share of domestic debt attributed to inflation-linked bonds across the globe

Table showing share of the domestic debt program by country.

Source: Bloomberg Global Inflation-Linked Total Return Index Value Unhedged USD, Bloomberg Global Agg Treasuries Total Return Index Value Unhedged USD, as of February 21, 2023. G7 countries are highlighted in green while other notable countries are highlighted in purple.

The cessation of the RRB program could therefore exacerbate an already illiquid market (RRB trading activity hasn’t exceeded 0.82% of overall federal bonds trading volume since 2018), putting upward pressure on liquidity premiums and acting as a major headwind for years to come; practical inflation hedging alternatives are therefore needed going forward. So what are the options investors can turn to? 

RRB trading activity has shrunk to its lowest level in 5 years

Monitoring RRB trading volume per month since 2018 (CAD, billions)

Line chart showing the decline in RRB trading volume over the years.

Source: IIROC, as of May 31, 2023.

If the goal is short-term inflation protection

Thankfully, U.S. CPI is “sufficiently” correlated with Canadian CPI (r=0.88), making U.S. Treasury Inflation-Protected Securities (TIPS) a viable substitute for inflation-focused investors. 

U.S. CPI is “sufficiently” correlated with Canadian CPI

Annual U.S. CPI vs. Canadian CPI, 1971–2022

Scatter plot showing the correlation between U.S. and Canadian CPI since 1971.

Source: Macrobond, December 1971 through December 2022.

Buying short-term TIPS and hedging back to local currency may be an option for investors looking for a low-risk, Canadian dollar-denominated inflation alternative to RRBs.

Short-term TIPS (0–5-year maturities) may track monthly and yearly U.S. (and by extension, Canadian) inflation more closely than their longer-term counterparts, making them a good fit for hedging inflation over shorter horizons, in our view. The main reason for this is their shorter duration, or lower interest-rate risk. Compared with the aggregate TIPS market (or even just their longer-term equivalents), shorter-term TIPS tend to be less prone to price volatility because their inflation-adjusted income payments tend to drive a more sizable portion of total return.

If the goal is long-term inflation protection

It goes without saying that transitory spikes in inflation could have a detrimental effect on the ability of an investor (such as a pension fund sponsor) to meet future liabilities. After all, higher short-term inflation expectations have an impact on the actuarial assumptions used to calculate the present value of future liabilities. In the case of a CPI-indexed pension plan, for instance, a short-term inflation rate of 7% would increase the liabilities of the plan by roughly 5% if a 2% inflation rate was assumed. Of course, this effect would be exacerbated by longer bouts of higher inflation. Under the assumption of a persistent inflationary backdrop, we would have to gauge the sensitivity of future liabilities to a change in inflation with a measure called liability inflation duration (LID).

We believe matching liability inflation duration with inflation-linked bonds is the optimal solution for hedging inflation over prolonged periods of time but, again, investors aiming to start an inflation hedge program now might need to look to U.S.-based alternatives and hedge back to local currency. Fortunately, with a correlation of 0.86, the long-term break-even inflation rate in the United States closely mirrors the long-term break-even inflation rate in Canada, again emphasizing the parallels between the two countries. 

Long-term inflation expectations in Canada and the U.S. are closely aligned

Tracking break-even inflation rates in the U.S. and Canada

Line chart illustrating the break-even inflation rates of the U.S. and Canada.

Source: Bank of Canada, U.S. Treasury Department, as of November 11, 2022.

By combining a long position on TIPS with a short position on Treasuries and CAD/USD FX management, investors could lock in the prevailing U.S. long-term inflation expectations (or break-even inflation rate). Of course, it would be important to match the LID when implementing this trade, but what’s interesting is that this strategy would add synthetic exposure to inflation only and free up capital to invest in higher-yielding asset classes such as corporate bonds and equities.  

A reminder of the inflation hedging potential of real assets

While there are plenty of reasons to consider investing in real assets,   investors could also rely on the long-term inflation protection conferred by this asset class. In the context of real estate and infrastructure companies, pricing power, shorter and more adaptable leasing provisions, periodic resets, and even the regulatory environment could permit them to easily adjust their revenues to inflation. By allowing them to pass the burden of higher prices through their rents, utility rates, or tolls to their customers, these companies can provide a degree of protection that can be of particular benefit in a heightened inflationary environment; elsewhere, timberland, farmland, and commodities also possess viable inflation hedging attributes. For timberland, the fact that timber is a direct or indirect input—often used in the production of goods and services in a growing economy—makes it less likely to be affected by inflationary pressures. In a similar fashion, agricultural products are deemed to be a core component of the economy and the CPI (just as commodities such as crude oil and natural gas are directly linked).

Over the last two decades, real assets have offered good protection in times of high inflation, making them a great diversifier for traditional stocks and bonds and a potentially valuable alternative for investors. 

Real assets have outpaced traditional asset classes in periods of high inflation

Average annual returns of real assets vs. traditional asset classes, December 2001–December 2022

Bar charts showing the potential of real assets vs. traditional asset classes in inflationary times.

Source: Average 12-month rolling annualized returns from December 31, 2002, to December 31, 2022. Returns in U.S. dollars for the representative indexes: farmland, NCREIF Farmland Index; U.S. real estate, NCREIF Real Estate Index; infrastructure equities, S&P Global Infrastructure Index; timberland, NCREIF Timberland Index; commodities, S&P GSCI Index; U.S. bonds, Bloomberg U.S. Aggregate Bond Index; U.S. equities, S&P 500 Index; direct infrastructure, Burgiss Global Infrastructure Pooled Composite Index. Returns in CAD for representative indexes: Canadian equities, S&P/TSX Composite Index; Canadian bonds, FTSE Canada Universe Bond Index. U.S. Consumer Price Index (CPI) data is from the U.S. Bureau of Labor Statistics. Rising inflation is defined as periods in which the annual U.S. CPI is greater than 2.5%, and falling inflation is defined as periods in which it is less than 2.5%. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Adapting to the new reality

Even if RRBs are narrowly held, they serve an important purpose for a select group of institutional investors (mainly pension fund sponsors). While inflation has come down, it’s still a disruptor, prompting the need for alternatives to offset this risk.

Choosing between the short- or long-term options proposed above is a trade-off and dependent on an investor’s objectives and expectations for future inflation. Is inflation transitory or a longer-term threat? In the short run, the alternatives proposed may help achieve an additional asset-only return to compensate for the temporary spike in inflation. Over longer horizons, real assets, or a strategy of matching liability inflation duration, could offer good protection.

Whatever the objective, there’s no set tool or strategy that will act as a perfect substitute for Canadian RRBs. Like any investment, market participants need to rely on diversification and weigh the pros and cons of all inflation hedging strategies at their disposal. 

Investing involves risks, including the potential loss of principal. Diversification does not guarantee a profit nor protect against loss in any market. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments.  These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

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Jean-Francois Giroux, FRM, CFA

Jean-Francois Giroux, FRM, CFA, 

Portfolio Manager, Head of Liability-Driven Investments—Canada, Multi-Asset Solutions Team

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Emilie Paquet, FSA

Emilie Paquet, FSA, 

Head of Strategic Initiatives and Innovation, Multi-Asset Solutions Team

Manulife Investment Management

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