Inflation-linked bonds disappoint whilst they ship on their promise

Bond market upsets aren’t a typical function of Canadian funds, however one revolt seems to have begun there lately. Buried in a 96-page economic update late final yr, Canada’s finance ministry led by Chrystia Freeland killed off its inflation-protected bond issuance programme — even because the nation battles its worst worth pressures for 40 years.

Quick-rising costs and their impression have been the dominant theme throughout world markets previously yr, placing a highlight on bonds that promise safety towards inflation’s value-eroding results. They pay out fastened curiosity like common authorities bonds however commonly modify the principal — the lump sum repaid on the finish — according to inflation charges.

Ottawa’s choice is thus an actual insurrection within the slow-moving world of bond fashions, the place authorities debt managers normally prize gradual, well-signalled strikes that don’t upset bond patrons. Additionally they have a tendency to observe their friends carefully: when one succeeds in opening a marketplace for, say, ultra-long 50-year bonds or finds demand for “inexperienced” debt to fund environmentally pleasant tasks, others comply with.

Canada, an early adopter of “actual return” bonds in 1991, has dropped its programme with speedy impact, and is now an exception amongst G7 nations. Even Japan, nonetheless principally involved about deflation, sells some safety.

Ottawa cited low demand as a think about its choice and pointed to the outcomes of trade consultations in earlier years. Nonetheless, the transfer has prompted howls from pension funds and others who use the merchandise to assist meet liabilities stretching out over many years.

“Mistaken sign, unhealthy timing,” mentioned the Canadian Bond Traders’ Affiliation, representing fund managers holding some $900bn in property. It called for a rethink. “Now greater than ever traders have larger curiosity in inflation-protection merchandise.”

Bond traders are highly effective gamers given their monetary heft and position in financing governments. A committee advising the Financial institution of Canada additionally voiced disquiet, with some members fretting that the transfer may create a notion that the federal government feared it couldn’t absolutely include inflation.

Past the choice by Freeland’s ministry and investor misgivings, there’s an uncomfortable reality about how about inflation-linked bonds work.

Take efficiency. The US gives the biggest inflation-linked market with its Treasury inflation-protected securities. Traders monitoring Bloomberg’s complete return Ideas index misplaced virtually 12 per cent final yr, whereas one following common US bonds on the identical foundation misplaced 12.5 per cent.

In different phrases, Ideas’ short-term efficiency fell sufferer, and virtually as badly, to the identical components as their common cousins — specifically, the Federal Reserve’s unusually sharp collection of rate of interest rises. The Fed pushed bond costs down quicker than may very well be countered by pricing in rocketing inflation.

“Inflation-linked bonds typically carried out final yr precisely how they need to have achieved given the atmosphere,” says Michael Pond, world head of inflation market analysis at Barclays. “There’s been loads mentioned within the final yr about utilizing them as safety towards inflation however they solely assure you that actual return in case you maintain them to maturity. They’re not safety over short-term horizons.” 

That buy-and-hold rationale fits these with distant horizons corresponding to pension funds and insurers, however the ensuing lack of liquidity can push up the prices for smaller issuers by widening the hole between the costs patrons and sellers can pay.

“Debt administration workplaces are charged with issuing bonds that minimise expense. Inflation-linked bonds in all probability aren’t essentially the most environment friendly for smaller debtors like Canada on that foundation,” mentioned Darrell Duffie, Stanford professor and bond markets specialist.

Round 2 per cent of Ottawa’s borrowing was in actual return bonds earlier than it dropped the programme, whereas Ideas account for roughly 8 per cent of Washington’s issuance.

For instance, the US Treasury on Thursday bought $9bn in 30-year Ideas, garnering extra in a single deal than Canada did from its mixed gross sales of actual return bonds for the previous 5 years.

Regardless of Ottawa’s revolt towards bond market orthodoxy, others are holding the inflation-protected line. Traders took up a file 90.1 per cent of this week’s US deal, leaving sellers — banks which commerce within the bonds — with far fewer bonds than common.

Nonetheless, shopping for inflation safety appears more likely to stay considerably of a distinct segment market and demand is unlikely to spike instantly. Which will depart Ottawa comfy in its choice. However with its friends dealing with far bigger debut burdens, the insurrection is unlikely to unfold.

jennifer.hughes@ft.com