TORONTO — Canada is under pressure to reverse its decision to stop issuing bonds, a product that pension funds rely on to ensure inflation, which is currently the most volatile in decades, can wipe out the assets they’ve set aside. to pay benefits to retirees.
Surprisingly, the Canadian government said earlier this month that it had decided to stop issuing real return bonds (RRBs) due to low demand.
The bonds, which pay a coupon tied to the consumer price index level, are generally less liquid than regular bonds, with investors demanding a discount to buy them.
That makes them an expensive form of government funding, but cost shouldn’t be the only consideration, investors say.
Indexed pensions pay benefits to retirees that are linked to inflation. Taking away the supply of an investment opportunity that tracks inflation could make it more difficult for those plans to meet their obligations.
“Inflation is high and there were many plans to get more into this asset class, and now the asset class has been removed,” said Ashwin Gopwani, general manager, client solutions at SLC Management, which manages investments for retirement plans.
The median allocation by defined benefit plans, a major category, to RRBs was 5.2 percent in 2021, according to data on members of the Pension Investment Association of Canada (PIAC).
The association’s board will meet next week to look at the impact of the government’s move, PIAC said.
In an email to Reuters, the Canadian government said it had conducted extensive consultations in 2019 that showed low demand for RRBs, and this was reinforced in recent consultations with market participants.
With about $49 billion in RRBs outstanding, the market is too small for the largest pension funds to adequately hedge their inflation risk.
They have moved into other types of assets, such as real estate and infrastructure projects, but those assets are less suitable for smaller, more mature retirement plans.
“It’s a tough bet for medium-sized subscriptions paying out their last members in the next 10 or 20 years. They may not have the time frame to earn those returns and hope to keep up with inflation,” Gopwani said.
Annual inflation in Canada remained stable at 6.9 percent in October. It is not expected to return to the Bank of Canada’s two percent target until late 2024, the central bank said last month.
In a letter this week, the Canadian Bond Investors’ Association (CBIA), which represents investors who manage more than $1.2 trillion in fixed income assets, urged the government to reverse its decision, citing a strong and ” potentially growing demand” is for RRBs. in the current inflationary environment.
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Investors can still hedge against the outstanding stock of RRBs, but say the market has already become less liquid and bonds could become scarce.
US Treasury Inflation-Protected Securities (TIPS) can serve as a proxy, but are not an exact hedge against Canadian inflation.
Adding to investor consternation is the likely distortion of the measure of inflation expectations that the RRB market captures through its break-even rates. Breakeven percentages are the difference between yields on nominal and real yield bonds.
“RRBs must be given the opportunity to prove their worth in a world of great uncertainty about Canada’s economy, inflation and government finances,” National Bank of Canada strategists including Warren Lovely said in a note.
© Thomson Reuters 2022
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