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The government may wish to avoid inflation-protected bonds, because it thinks inflation will get a lot worse than markets do. But betting in markets is not a responsible strategy.Sean Kilpatrick/The Canadian Press

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and author of The Fiscal Theory of the Price Level, available January, 2023. Jon Hartley is a PhD student in economics at Stanford University and a research fellow at the Foundation for Research on Equal Opportunity.

Finance Minister Chrystia Freeland recently announced that the government of Canada will no longer issue inflation-protected “real return” bonds. A kerfuffle erupted.

The government may wish to avoid inflation-protected bonds, because it thinks inflation will get a lot worse than markets do. But betting in markets is not a responsible strategy.

If the government won’t do it, corporations, banks and financial institutions should issue these bonds themselves rather than just complain. Not every asset must be provided by the government.

Real return bonds adjust both principal and interest for inflation. If inflation goes up, you get more money back. Nice. But when everyone expects inflation, you pay a commensurately higher price ahead of time.

With 5-per-cent inflation, say, a real return bond might pay 1 per cent, so you get 6 per cent after inflation adjustment; but a regular bond will pay something like 6 per cent already. Like everything in finance, it’s really about risk: Real return bonds protect against the risk that inflation will turn out worse than bond markets expect. Regular bonds have lost 11 per cent of their real value since January, 2021, because of inflation that markets did not expect. Those who bought real return bonds were protected from this risk.

For this reason, long-term real return bonds are very useful, and ought to be more popular than they are. They can provide a steady stream of real payments immune from inflation or interest rate risk. As such, they can make an ideal component of any long-term portfolio, such as a retirement portfolio or an endowment. So, complain the members of the Canadian Fixed-Income Forum and other Canadian pension managers, it is a huge mistake for the government to stop providing this useful asset. Good point.

The government answers that the bonds are not “liquid,” meaning you can’t always sell them quickly at a good price. But why does the government care about liquidity? The point of bonds to the government is to raise revenue at a good rate, and the point of long-term real return bonds to the investor is precisely to live off the coupons and not to trade them actively. Moreover, if liquidity is an issue, the government can easily improve it by issuing perpetuals and simplifying the bonds’ tax treatment.

So why stop issuing real return bonds? The government may suspect that inflation will go up a lot more, and it will then have to pay more to bondholders. Non-indexed debt can be inflated away if the fiscal situation worsens. The cumulative 11-per-cent inflation since January, 2021, has inflated away 11 per cent of the debt already. Argentines have seen a lot more.

But issuing indexed debt makes sense if the government plans to be responsible. Tax payments and budget costs rise with inflation, and fall with disinflation, so the budget is stabilized if inflation-indexed bond payments do the same. And issuing indexed debt that can’t be inflated away is a good incentive not to turn around and inflate debt away.

Indexed debt is also a very useful signal, as it gives a market-based measure of inflation expectations.

If the government won’t do it, however, there is no reason that the government’s critics can’t issue them. Companies can issue real return bonds, as they already issue U.S. dollar bonds. Banks can offer real return accounts and certificates of deposit.

If the government steps out of the market, there’s all the more demand for private issuers to step in. Pension funds desperate to replace vanishing inflation-indexed government bonds are natural clients. Company profits rise and fall with inflation, so they have a natural incentive to issue bonds whose payments rise and fall with inflation. Even mortgage rates could rise and fall with an index of wages.

Why not? Broadly, this reluctance seems one more symptom of an overleveraged, overregulated, government-dependent and not very competitive or innovative banking and financial system. Banks and other financial institutions only want to issue or expand a new product if they can quickly lay off the risk onto the government, and earn steady fees. The model of issuing equity to bear risk and then offering a profitable innovative product to consumers is too out of fashion.

Bring on the real return bonds. And if government won’t do it, make your own.

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