Ottawa should reverse cancellation of inflation-linked bond program

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Ottawa should reverse a controversial decision to stop issuing real return bonds and instead expand the program, diversify lending terms to help finance the national debt and provide access to the inflation-indexed asset class that is very much in demand by the country’s largest pensions, according to a new report from the C.D. Howe Institute.

“The government’s cancellation of the RRB program means that Canadian savers will have less access to a uniquely valuable tool to protect themselves from inflation,” the report said. “The pension funds and other institutions that invest on individual Canadians’ behalf will lose a key tool to help them deliver on their promises.”

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The report, written by William Robson and Alexandre Laurin, said the government justified the cancellation because of weak demand and illiquid markets, but that it did not take into account that its management of the real return bond program — notably the small amounts issued and lack of diversity in maturities —  discouraged investors from buying and holding RRBs.

The government could have increased the float to improve liquidity, demand and pricing when institutional investors complained of a lack of liquidity in the secondary market during consultations in 2019, but it “paradoxically” opted to reduce annual RRB issuance to $1.4 billion from $1.8 billion, the report said.

The subsequent cancellation of the program led to “suspicions that it anticipated consistently higher inflation in the future,” the authors said, suggesting that reversing that decision would also strengthen Canada’s commitment to maintaining inflation at two per cent.

A commitment to controlling inflation was a clear objective of the RRB program from its early days in the 1990s since it would visibly diminish the fiscal advantages of higher inflation, they said.

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In addition to expanding the program’s size, the authors suggested that a more liquid RRB market with 10-year or shorter maturities could promote the development of derivatives and more inflation-linked products, notably price-indexed annuities and vehicles providing coverage for disability and long-term care.

Backing the research is a C.D. Howe survey that tapped the opinions of 13 institutional investors with $2.6 trillion of assets under management — and substantial holdings of RRB — about the surprise cancellation of the program in late 2022.

None of them supported the government’s decision, with 12 opposing it and one with no opinion, and they said that if the government were to resume issuing the inflation-indexed securities, they would likely buy $7.9-billion worth over the next three years.

Canada has been issuing RRBs since 1991 and the report noted that the amount of inflation-linked debt issued has always been small relative to other governments, such as the United Kingdom, Australia and the United States.

The asset class is highly desired by pensions, which make long-term promises to retirees that are often indexed to inflation. While some inflation hedging can be accomplished by investing in asset classes such as global infrastructure and real estate, the match isn’t exact — a key factor for pensions indexed to inflation — due to foreign currency and inflation risks, the report said. 

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And with no new issuance, the existing stock of inflation-linked bonds will shrink as the bonds mature, falling 35 per cent within the next 12 years and being fully eliminated in 30 years. 

Other domestic issuers, which have no control over inflation targets, are unlikely to fill the gap left by the federal government, the report said.

“Further thinning of the market for RRBs will likely adversely affect the availability and pricing of other indexed products: indexed annuities, for example, will likely become more expensive,” the authors said.

They added that even if there was some rationale for reducing the issuance of the inflation-linked securities in an era of below-target inflation and limited government financing requirements before the COVID-19 pandemic, conditions have changed.

“The federal government should resume issuing RRBs — in greater amounts and with more diversity of terms than before,” they said.

The response to the cancellation of the RRB program in November 2022 was swift. Jim Keohane, a veteran pension executive and director at Alberta Investment Management Corp. (AIMCo), said he thought the justification offered by Finance Minister Chrystia Freeland was “not legitimate.”

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The limited consultation the government undertook also came under fire from Bert Clark, chief executive of Investment Management Corp. of Ontario and Canadian senator Clément Gignac, an economist and former Quebec cabinet minister.

The pension experts said infrequent trading did not indicate low demand, noting that long-term investors such as pension funds tend to buy and hold RRBs, not trade them. Moreover, Keohane said that in his experience, which spanned two decades at the Healthcare of Ontario Pension Plan before he joined AIMCo, any government issue of real return bonds would be “oversubscribed.”

A group of fixed-income experts convened by the Bank of Canada, which included representatives from Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Bank of America Corp., Healthcare of Ontario Pension Plan and Canadian National Railway Co.’s investing division, also disagreed with the government’s decision to cancel the RRB program, according to the minutes of their Nov. 29, 2022, meeting.

• Email: bshecter@postmedia.com

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