The federal government earlier this month announced it would cease issuing real return bonds, a product that’s been in existence since 1991. The decision has sparked pushback from fixed-income market participants, but for most investors, the termination of the program shouldn’t be a big loss.
Real return bonds (RRBs) are credit issues from the Government of Canada that provide protection from inflation. They aim to provide a cash flow that keeps pace with increases in the cost of living. The bonds provide a semi-annual interest rate that is adjusted for inflation based on the Consumer Price Index (CPI). The principal amount is also indexed to protect the bondholder from price erosion.
On the surface, one can understand their appeal. But the federal government points out that demand for them has been poor.
One reason is that investors, up until 2020, had not been overly concerned with inflation. Consumer price gains were relatively modest, and returns in stocks and real estate far outpaced inflation over the past few decades.
In the early 1990s, Canada was struggling with a recession that seemed to hit us harder than most parts of the developed world, owing to a relatively poor fiscal situation and the aftermath of a residential real estate bubble. Canada’s reputation in international capital markets had deteriorated, and market players were beginning to question our government’s fiscal responsibility and its seeming tolerance of inflation compared with the United States in the Ronald Reagan/George H.W. Bush era of the 1980s and early 1990s.
When RRBs were first announced, market players had mixed reactions. Some felt that the federal government was signalling to the markets that they were serious about fighting inflation. The issuance of RRBs incentivized the government to maintain low inflation, since a surge in consumer prices would end up dramatically adding to interest costs.
Some active fund managers actually feared that RRBs would wipe out a good deal of the active management industry since the expected returns of these instruments over the long term were expected to be about the same as a balanced asset allocation fund.
Many managers assumed that RRB issuance would end up being dramatically higher than it turned out to be. RRBs never got to be a large part of the market. At its peak, annual issuance was never significantly more than $2-billion annually, which is a small amount in an economy the size of Canada’s. Currently, there are $48.6-billion of these bonds outstanding, with the longest date issue maturing in 2054, according to Bloomberg data.
My reaction to the RRB program was initially positive. I saw this as an opportunity to trade another product in my bond portfolio that hopefully does not correlate highly with standard bonds. Bond managers have a significant disadvantage to active stock portfolio managers because bonds as an asset class correlate more closely than stocks, and have less volatility. That is why hot equity managers outperform their benchmarks more dramatically than fixed income managers.
But I later abandoned using RRBs in client portfolios for two main reasons. First, to the benefit of the developed world economy, we were entering a period of disinflation, followed by a prolonged period of low inflation. Canadian CPI dropped from 6.9 per cent annualized in January, 1991, to 3.8 per cent in December of that same year. The federal government understood that we were entering an era of disinflation, so issuing debt tied to future inflation would be a cheap form of funding.
The second reason is that RRBs turned out to be highly correlated with regular bonds. They soared in price when interest rates were declining and dropped when rates went up. RRBs really did not lower portfolio risk and provided little diversification. Furthermore, they were less liquid than regular government bonds.
When inflation reared its ugly head again a couple of years ago, RRBs failed to offer much benefit. The regular bond market crashed and yields went up to the levels that offset the perceived advantage of RRBs. They were always a niche product. Yes, they worked if you had to offset a specific set of liabilities tied to CPI, but returns on markets have been significantly higher than inflation over the past three decades. The TSX oil and gas sector, for example, proved a much better hedge against inflation and rising rates.
The Canadian Bond Investors’ Association this week asked the federal Finance Department to reverse its decision to cease RRB issuance. It argues some of the smaller institutions that use them with products such as indexed annuities may face higher volatility and portfolio risks. The government, for its part, said it consulted market participants before making its decision.
Regardless, I think regular bonds currently offer better value for most investors. Yields have exploded over the past couple of years but inflation seems to be finally coming down. Unless inflation unexpectedly starts climbing again, there’s not a convincing reason to buy them.
And if Ottawa proceeds with plans to no longer issue real return bonds, they will become less and less liquid as existing bonds reach maturity. Many of the current institutional holders of RRBs might be reluctant to part with their positions, exacerbating the liquidity issue.
If investors want to partially hedge inflation, there are effective tools outside of fixed income. These include commodity stocks, shares of companies that benefit from inflation through pricing power and some areas of real estate.
RRBs were a noble experiment, but, like many experiments, they worked better in theory than in practice.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.