Ottawa should reverse the repeal of the inflation-indexed bond program

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Ottawa should reverse a controversial decision to stop issuing real yield bonds and instead expand the program, diversify credit terms to help finance public debt and provide access to the inflation-indexed asset class that is in high demand among the country's largest pension funds, a new report from the CD Howe Institute says.

“The government's elimination of the RRB program means Canadian savers will have less access to an extremely valuable tool to protect themselves against inflation,” the report said. “Pension funds and other institutions that invest on behalf of individual Canadians will lose an important tool that helps them keep their promises.”

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The report, written by William Robson and Alexandre Laurin, said the government justified the cancellation by citing weak demand and illiquid markets, but failed to take into account that the way the real yield bond program was managed – particularly the small amounts issued and the lack of maturity diversity – discouraged investors from buying and holding RRBs.

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

The subsequent cancellation of the program “raised suspicions that there was an expectation of permanently higher inflation in the future,” the authors said. Reversing this decision would also strengthen Canada's commitment to keeping inflation at two percent.

The commitment to control inflation has been a clear objective since the beginning of the RRB program in the 1990s, as this would visibly reduce the fiscal benefits of higher inflation, it said.

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In addition to expanding the scope of the programme, the authors suggested that a more liquid RRB market with maturities of ten years or less could encourage the development of derivatives and more inflation-indexed products, in particular price-indexed pensions and disability and long-term care instruments.

The research is supported by a survey by CD Howe that asked the opinions of 13 institutional investors with $2.6 trillion in assets under management – ​​and significant RRB holdings – on the surprise termination of the program at the end of 2022.

None of them supported the government's decision, 12 opposed it and one had no opinion. They said that if the government resumed issuing inflation-indexed securities, they would likely buy $7.9 billion worth of securities over the next three years.

Canada has been issuing RRBs since 1991 and the report found that the amount of inflation-indexed debt issued has always been small compared to other countries, such as the United Kingdom, Australia and the United States.

The asset class is in high demand among pension funds because they make long-term commitments to their retirees that are often indexed to inflation. While investing in asset classes such as global infrastructure and real estate can provide some protection against inflation, currency and inflation risks mean the match is not exact – a key factor in inflation-indexed pension funds – the report said.

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And if no new issues are made, the supply of inflation-indexed bonds will shrink as bonds mature, falling by 35 percent over the next 12 years and disappearing completely in 30 years.

Other domestic issuers that have no influence on inflation targets are unlikely to fill the gap left by the federal government, the report said.

“Further thinning of the market for RRBs is likely to negatively impact the availability and pricing of other indexed products: indexed annuities, for example, are likely to become more expensive,” the authors said.

They added that while there had been some justification for reducing the issuance of inflation-linked securities prior to the Covid-19 pandemic at a time of below-target inflation and limited government financing needs, conditions have changed.

“The federal government should resume issuance of RRBs – in larger amounts and with more variety of maturities than before,” they said.

The reaction to the cancellation of the RRB program in November 2022 was swift. Jim Keohane, a veteran pension manager and director at Alberta Investment Management Corp. (AIMCo), said he found the reasoning put forward by Finance Minister Chrystia Freeland to be “not legitimate.”

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The government's limited consultations were also criticized by Bert Clark, chief executive of the Investment Management Corp. of Ontario, and Canadian Senator Clément Gignac, an economist and former Quebec cabinet minister.

Pension experts said the infrequent trading is not a sign of low demand, noting that long-term investors such as pension funds tend to buy and hold RRBs rather than trade them. In addition, Keohane said that in his experience – which he gained over two decades at the Healthcare of Ontario Pension Plan before joining AIMCo – any government issue of real yield bonds is “oversubscribed.”

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

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