Wednesday, February 1, 2023

RIP Indexed Bonds in Canada

(An oped at Globe and Mail with Jon Hartley) 

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.


27 comments:

  1. "long-term real return bonds are very useful, and ought to be more popular than they are.". An interesting observation is that here in Brazil they (called NTN-Bs) are really popular, to the point that the Tesouro Nacional is now creating an inflation protected bond that mimics life-time accumulation and distribution phases. The causes are obvious.

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  2. FIPDX lost 18% between 1/1/2021 and 1/1/2023. This an ETF trading on the NASDAQ market system and having as its underlying securities U.S. government TIPS. By way of comparison, an 11% loss over the same period looks decidedly more advantageous.

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  3. "The government answers that the bonds are not “liquid,” meaning you can’t always sell them quickly at a good price."

    The authors misapprehend the government statement. The government is saying that the government auctions are not competitively bid -- O.I.D.s are greater in inflation protected securities and issue volumes are lower than in non-inflation protected government securities of comparable maturity. Given that realization and no compelling public interest (i.e., absence of a "social welfare improvement" mandate from Parliament comparable to that in the U.S.) the Governor General in Cabinet is predisposed to discontinuance of government issue inflation protected securities.

    Will private capital take up that fallen baton, as the authors suggest? The rational expectations investor would, if asked, answer in the negative. To the lack of market interest already noted by the government's remarks, add the certainty of not being able to layoff the risk efficiently in a very thin and inadequate market. It's not worth the candle.

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  4. "Real return bonds adjust both principal and interest for inflation. If inflation goes up, you get more money back. Nice."

    Not really. If your fiscal theory of the price level is correct, do the fiscal transfer payments via the inflation adjustment make things better or worse?

    Government overspends causing inflation, causing more spending via the inflation adjustment on it's indexed bonds.

    Instead this:

    https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

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  5. "Real return bonds adjust both principal and interest for inflation. If inflation goes up, you get more money back. Nice."

    If the federal government could pay a real return to everyone, why would anyone work for a living?

    ReplyDelete
    Replies
    1. Inflation indexed bonds with positive real returns are not that much different than government bailouts - privileged returns for a select few, but impossible to implement across an entire economy.

      Delete
  6. Do they give a market expectation for expected inflation, or the natural rate of interest? If its the latter they seem to be stating that natural rates has moved decidedly higher over the past 12 months than they have been the last decade. No doubt economists and their Kalman filters will be able to offer a second opinion in a year or two..... But does seem to be an odd time to stop issuing just when demand might pick up.

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  7. How would a private issuer hedge inflation risk?

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    Replies
    1. They wouldn't. They would bear risk and earn a return, like all insurers. Or, they would already be hedged. A corporation earns a real profit. If there is inflation, to first order, prices and costs rise at the same rate, so profit rises with inflation. Then the corporation has the extra money to pay the inflation indexed bond. And vice versa. The corporation, or anyone else with a real income stream, is naturally already hedged. Indeed, the current situation is puzzling. Companies that borrow in nominal terms but have real profit streams are in deep trouble when there is deflation. That's what happened in the Great Depression. Deflation, farm and other prices collapsed, and borrowers were in big trouble. If they had issued inflation (and deflation) indexed debt they would have been much better off.

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    2. "Companies that borrow in nominal terms but have real profit streams are in deep trouble when there is deflation. That's what happened in the Great Depression. Deflation, farm and other prices collapsed, and borrowers were in big trouble. If they had issued inflation (and deflation) indexed debt they would have been much better off."

      Not really. You would have been asking banks (lenders) to absorb deflation risks and you would have ended up with the same failing banks (perhaps much worse).

      https://livinghistoryfarm.org/farminginthe30s/money_08.html

      "In all, 9,000 banks failed during the decade of the 30s. It's estimated that 4,000 banks failed during the one year of 1933 alone."

      Instead this:

      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      Borrowers purchase equity from the US Treasury that fully offsets the real cost of debt service. Real pre-tax cost of debt service high courtesy of deflation, real after-tax cost of debt service low because of the fiscal offset.

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    3. At the time of the Great Depression, the interest payments made on federal government debt were payable in gold. And so debt financed government expansion placed a strain on the gold reserves held by the US Treasury.

      Equity financed expansion places a "strain" on future government tax revenues, but since those revenues can be considered infinite over an infinite time frame, there is no strain at all. Instead the limiting factor on the ability of the federal government to sell equity is risk tolerance within the private sector.

      This:
      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      Delete
    4. "That's what happened in the Great Depression. Deflation, farm and other prices collapsed, and borrowers were in big trouble. If they had issued inflation (and deflation) indexed debt they would have been much better off."

      Any reasonable approach would have looked to keep both the farmer AND the bank lending to the farmer both in operation.

      This:
      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

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    5. Totally agree with keeping governments honest. But private issuers without a market to hedge the risk seems far-fetched. Who is on the other side? Some US insurers used to offer inflation-adjusted payout annuities. Hedging costs were high and demand limited even with the TIPS market available to hedge--the products were abandoned. Can't imagine introducing equity risk ("real income streams") via private issuers would fare better. At the end of the day only the government can sell inflation protection.

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    6. Peter H,

      "At the end of the day only the government can sell inflation protection."

      To a privileged few, sure. Think about it. It government could sell inflation protection to everyone, why would anyone work for a living producing goods and paying taxes?

      Delete
    7. "At the end of the day only the government can sell inflation protection."

      To a few privileged investors, sure. To everyone, not possible.

      If government could provide everyone any type of positive real income, why would anyone work or pay taxes?

      Delete
  8. Liquidity is definitely a problem when it comes to things like inflation linked bonds, particularly in a very small very illiquid market like RRBs. The government in the end does have to sell the securities to buyers, the less liquid the product is the more the government has to end up paying the primary dealers to intermediate the risk for end users.

    We tend not to think about liquidity much in the US because the Treasury market is so massive and because there is a lot of competition among primary dealers.

    ReplyDelete
    Replies
    1. The only reason that bonds (including inflation linked bonds) "need" to be liquid is that a government cannot reasonably sell them on demand (see Ponzi limit).

      Why would I buy a government bond second hand if the government was selling them to all comers regardless of whether that government was running a surplus or deficit?

      Instead this, sold on demand (regardless of deficit or surplus):

      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      Delete
  9. Inflation is not an insurable peril. It's a certainty. No Canadian corporation would willingly provide cover to another Canadian corporation seeking to hedge against inflation. It's one thing for the U.S. government to offer inflation-protected securities in the U.S. on the premise that doing so improves social welfare, it is quite another thing for a private corporation to undertake the obligation of social welfare improvement by issuing inflation-protected securities. It will be noted that the complainants in Canada are pension funds and insurers of pension funds that are desirous of hedging against inflation cheaply. Private corporation C.F.O.s are, almost surely, not compensated for assuming the other side of the pension funds' appetite for hedging their inflation exposure.

    Now, if you were proposing to create a market in futures for the purpose of speculating and hedging on the CPI or PCE price indices, then that would quite a different undertaking and it might have some merit to it. But that is not what your remarks would led one to assume that you're proposing that Canadian corporations undertake. If there is one characteristic common to successful publicly-listed private corporations resident in Canada, it would be avoidance of taking on unnecessary risks leading to losses. Like the proverbial "Canadian banker" with deep pockets but short arms, Canadian private corporations are loathe to part with their hard-earned money.

    ReplyDelete
    Replies
    1. "It's one thing for the U.S. government to offer inflation-protected securities in the U.S. on the premise that doing so improves social welfare, it is quite another thing for a private corporation to undertake the obligation of social welfare improvement by issuing inflation-protected securities."

      Inflation protection is only "needed" because you think that deflation is something that "needs" to be avoided.

      Instead this:
      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      Delete
    2. Does deflation improve social welfare? If so, then why do you need inflation protected bonds to do so?

      Delete
    3. Thanks for the response, FRestly. "Government equity", as a concept is foreign to the Canadian government. It won't ever be considered, and if considered it won't ever be adopted.

      In the U.S., TIPS are protected against deflation. Treasury guarantees that the holder will receive not less than par value for each bond she owns at the maturity date. This feature is built in to TIPS. Why? Because this too was considered to be social welfare improving.

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    4. "In the U.S., TIPS are protected against deflation. Treasury guarantees that the holder will receive not less than par value for each bond she owns at the maturity date."

      Nope. You are supposing that the owner of the TIPs lives to maturity or doesn't require those TIPs to be liquidated. You are also supposing that TIPs can be sold by Treasury on demand rather than as a function of government deficits.

      Suppose that holder of the TIPs dies prior to maturity or needs to liquidate to cover other expenses. The estate / the owner may be forced to sell that bond into the market, and during deflation would be selling at potentially heavy losses.

      That is one significant advantage of the equity I described. It is can be sold on demand by Treasury (regardless of deficit or surplus) thus there is no need for it to be a marketable asset.

      Social Security benefits are an example of a sold on demand, non-transferrable asset (with some exceptions), this would be another.

      And finally, you sidestepped the question. If deflation improves social welfare, then why do you need inflation protected bonds to do so?

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    5. Your statement,

      "It's one thing for the U.S. government to offer inflation-protected securities in the U.S. on the premise that doing so improves social welfare..."

      Which is a false premise. It is IMPOSSIBLE for a government to offer an inflation protected income to all the people that it governs.
      If it could, why would anyone work, produce goods, and pay taxes?

      Inflation protected securities instead offer privileged welfare, not that much different from the bank bailouts the US went through.

      Leading the charge on both fronts - Larry "Free Lunch" Summers.

      When TIPs and I-Bonds were introduced, Larry was in the Treasury Department under Bob Rubin.

      When the bank bailouts were instituted, Larry was Obama's White House National Economic Council Director.

      Delete
    6. "It's one thing for the U.S. government to offer inflation-protected securities in the U.S. on the premise that doing so improves social welfare..."

      Which is funny, because the legally mandated responsibility of any central bank is to maintain price stability (whether that be a Canadian or a US Central bank).

      So again, with a central bank already in existence with a clear directive to maintain price stability, why are TIPs / I-Bonds even needed?

      Delete
    7. Note the individual protected against deflation is the holder, or holders, of the TIPS bond between the original issue date and the maturity date. The holder can be an individual, a business firm or corporation, a fund (pension or insurance), an estate, &c.

      "Social welfare improving" is a term used in the economics literature. Whether or not the government can deliver that to the citizenry is really not relevant to the discussion of purpose of TIPS.

      It is not relevant to any discussion around the financing of Canadian government expenditure programs. It is the expenditure programs themselves that are presumed to be "social welfare improving". If the expenditure programs are not "social welfare improving", then it must be that expenditures are wasteful and should therefore not be undertaken in the first place.

      In Canada, there is no absolute right in property. M. Lametti, Minister of Justice, Government of Canada, has recently made this point in public very emphatically. Subjects of the Canadian Crown hold their property in fee simple (real property) or as personal chattels. If the Crown deems that it needs your property, it will legally take it. And, the Crown will determine what amount and form of compensation the owner of the property is due. It doesn't happen often, but it does happen from time to time.

      The Bank of Canada is an arm of the government of Canada. It is not an "independent central bank" in any sense of that term. The fiction is maintained, but the facts speak otherwise.

      A central bank may have a "price stability" aspect to its mandate given it by the political authority. That mandate is nothing more than a general guideline or goal. To answer your question, "[W]ith a central bank already in existence with a clear directive to maintain price stability, why are TIPs / I-Bonds even needed?", one needs look no further than the record of inflation in the U.S. or in Canada. For if the central bank had consistently delivered "price stability", i.e., zero inflation over a business cycle, then one would anticipate there will be no market demand for TIPSs. But given that the central bank has consistently failed to deliver "price stability" despite having a "mandate" to do just that, there is a demand for those securities. In sum: Failure to deliver on the "price stability" mandate gives rise to inflation; the rise of inflation gives rise to a demand for inflation-protected securities issued by the national government ("default-free" implicit).

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    8. "The Bank of Canada is an arm of the government of Canada. It is not an independent central bank in any sense of that term. The fiction is maintained, but the facts speak otherwise."

      The only fiction here is that a government (such as Canada) must borrow to fund deficits perpetuating an ill-perceived need for a central bank (lender) to be involved in a government's finances.

      The fact is a government (again such as Canada) can either borrow or sell equity - see capitalism consisting of both debt and equity markets.

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    9. Thanks for the comment, "FREstly". The Canadian government does offer that ability through quarterly installments of personal and coporate income taxes. The government pays 1% to 3% per annum, simple interest, on the excess of quarterly installment amounts and final annual tax payments over the government's final assessment of the tax payer's annual tax liability. The Canadian government's Canada Revenue Agency collects provincial government taxes for every province and territory, except the province of Quebec. The overpayment of provincial income taxes through quarterly installment payments is therefore accorded the same beneficial treatment as overpayment of federal income taxes. By the same token, underpayment of income taxes begets penalties and interest costs for both federal and provincial tax payers. Canadians, by nature, are highly risk averse. "Government equity" via the income tax is a preferred option for such individuals.

      Delete

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