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Freeland's rationale for ending inflation-adjusted bonds 'not legitimate': veteran pension fund manager

Canada's Deputy Prime Minister and Minister of Finance Chrystia Freeland arrives to the Public Order Emergency Commission in Ottawa
Canada's Deputy Prime Minister and Minister of Finance Chrystia Freeland arrives to the Public Order Emergency Commission in Ottawa

The justification for Finance Minister Chrystia Freeland’s controversial decision to cancel a series of inflation-protected bonds “is not legitimate,” said Jim Keohane, a veteran pension executive and director at Alberta Investment Management Corp. (AIMCo), joining a group of fixed-income investors overseen by the Bank of Canada in criticizing the move.

Freeland abruptly decided last month to cease issuance of real return bonds, a useful inflation hedge for pension funds and other investors with long-term liabilities. Among the reasons stated for the decision was the bonds are illiquid and in low demand. Keohane said the securities rarely trade because institutional investors value them too much to give them up.

“The reason why the liquidity is lower is because the buyers are generally long term, hold-to-maturity buyers such as pension funds and insurance companies,” said Keohane, adding that bonds linked to inflation are particularly popular for funds that offer cost-of-living adjustments on pension payments.


“Lack of trading doesn’t equate to lack of demand,” he said.

Furthermore, because these long-term holders don’t trade the bonds, the only way to buy them is when the government issues them. And whenever that happens, they are snapped up.

“It is my experience that anytime the government has issued RRBs (real return bonds) they are oversubscribed,” he said.

Lack of trading doesn’t equate to lack of demand

Jim Keohane

Keohane spent two decades as chief investment officer and then chief executive of the Healthcare of Ontario Pension Plan (HOOPP) before being appointed to AIMCo’s board of directors in May 2021. He described a symbiotic relationship between the government that issues the bonds and investors with long-term liabilities that buy them.

Pension funds benefit in periods of rising inflation because cost of living adjustments are almost always tied to the consumer price index. The coupon on the bond is also tied to the index, so it pays out more, which offsets the pension fund’s liability.

The government has the opposite exposure because in times of higher inflation, government revenues rise.

“For example, in periods of high inflation, HST revenues will be higher because it is a fixed percentage of that inflated price,” Keohane said. “It is also a good hedge for governments in periods of lower inflation because the coupon payout on the bonds would be lower.”

Nevertheless, Keohane acknowledged that there could be reasons the government would opt against issuing real return bonds in certain economic cycles.

“If the current environment and pricing is not attractive for issuing real return bonds, there is nothing compelling the government to issue them,” he said, adding that Ottawa could simply switch to issuing nominal bonds until market conditions are more attractive.

Still, “that is certainly not a reason to cancel the program,” Keohane said.

The government said it had consulted with market participants before making the decision, and cited low demand as a principal reason for ceasing issuance of real return bonds. However, pushback from institutional investors was clear in the minutes of the most recent meeting of the Canadian Fixed-Income Forum, a group set up by the Bank of Canada to share information on the Canadian fixed-income market.

The 15-member group, which includes representatives from Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Bank of America, HOOPP and Canadian National Railway Co.’s investing division, “disagreed with the government’s reasons” for ending the program, according to minutes of the Nov. 29 meeting that were posted on the Bank of Canada’s website Dec. 16.

They said inflation-linked bonds “are a very important asset class that serves a crucial role in allowing Canadian investors to manage their exposure to inflation and, in a well-functioning market, provides central banks and markets participants with an important measure of inflation expectations.”

Moreover, the decision to eliminate new real return bond issuance deprived market participants of a way to express their inflation views, with some members indicating the decision “may create a perception that the government may not have full confidence in containing inflation,” the group said.

The fixed income forum committee is co-chaired by Jim Byrd, who is also co-chair of RBC Capital Markets, and Bank of Canada deputy governor Toni Gravelle. However, Bank of Canada officials recused themselves from the discussion of real return bonds because the central bank manages the federal government’s debt strategy, according to the minutes.

Some members of the fixed-income investor group felt Freeland’s handling of the government’s debt strategy “could lead to less demand or participation in the whole (Government of Canada) bond market going forward, and ultimately resulting in higher borrowing costs for the government than any potential cost saving it could get with the cessation of RRB issuance.”

In line with Keohane’s views, several members said demand for the real return bonds has increased in the current higher inflationary environment and is expected to increase further with the aging of the Canadian population, according to the minutes. They also pointed to the fact that Canada is now the only G7 country not issuing new sovereign inflation index-linked bonds.

“For retail and institutional investors, the cancellation removes a risk-free security that helps them manage short and longer-term inflation risks,” the group said.

Bert Clark, chief executive of Investment Management Corporation of Ontario (IMCO), which manages more than $70 billion of assets for public-sector clients in Canada’s largest province, said his organization owns real-return bonds and was surprised by the government’s decision to cease issuing them. 

“I hope that’s a decision they would be willing to reconsider,” Clark said in an interview Monday.

“They play an important part in our portfolio construction (and) provide effective protection against inflation, which is something that’s important for us because we manage liabilities, many liabilities that are inflation indexed.”

He also questioned the notion that limited trading means there isn’t demand for the bonds in the market.

“When when we buy them, we buy them to hold them because they match client liabilities well, and they serve as effective protection from inflation,” he said.  “We don’t buy them to trade them.”

Clark said IMCO was not consulted and received no warning ahead of the government’s decision.

“We didn’t see it coming and it was a surprise and (I) don’t have any idea of how it came about,” he said.

Reuters reported last month that the Canadian Bond Investors’ Association, which represents investors that manage over $1.2 trillion in fixed income assets, had sent a letter urging the government to reverse its decision on ending the issuance of real-return bonds, saying that there is a strong and “possibly growing demand” for them with current inflation levels far above the Bank of Canada’s target rate of two per cent.

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