Inflation-Linked Bonds Outstrip TIPS as Rate Increases End: Canada Credit

Canada’s real-return bonds are outperforming other debt as investors buy inflation protection after the Bank of Canada halted its interest-rate increases and the U.S. central bank signaled further debt purchases.

Returns on Canadian inflation-linked bonds more than doubled those of other domestic securities since Aug. 27, when Federal Reserve Chairman Ben S. Bernanke signaled the bank may add more stimulus to the economy through quantitative easing. Canada inflation bonds rose 4.5 percent since then, compared with 0.78 percent for Canadian government notes, 1.1 percent for corporate bonds and 1.8 percent for provincials and municipals, according to The Bank of America Merrill Lynch indexes. U.S. inflation-linked bonds returned 4 percent during that time.

“With the prospect of quantitative easing, there’s more demand by investors to protect themselves against potential inflation,” said Doug Porter, deputy chief economist at Bank of Montreal’s BMO Capital Markets unit in Toronto. “There’s also a growing view underlying this rally that real growth will remain quite weak for some time.”

The yield on Canada’s 4.25 percent inflation-linked bond due in December 2021 rose to 0.79 percent yesterday from 0.7 percent Oct. 25, the lowest since it was issued in 1991. Bank of Canada Governor Mark Carney last week cut his economic forecast for 2010 and 2011 and held interest rates steady after three increases since June.

Inflation Numbers

Bond investors’ expectations for Canadian inflation during the next decade touched 2.16 percent Oct. 25 -- the highest since May -- even as the Bank of Canada’s preferred core measure slowed to a rate of 1.5 percent in September. That underscores how the Fed’s possible moves weigh on investors’ strategies, said Sebastien Lavoie, an economist at Laurentian Bank Securities in Montreal.

“What happens in the U.S. will be so strong that we’re going to feel the aftershock all the way up here,” Lavoie said.

Elsewhere in credit markets, the extra yield investors demand to hold the debt of corporate rather than federal debt was unchanged yesterday at 142 basis points. Spreads were as wide this year as 154 basis points in June, Merrill Lynch data showed. Yields ended yesterday at 3.63 percent from 3.56 percent Oct. 25.

This month, the spread on corporate bonds has narrowed 3 basis points, compared with 7 basis points of tightening on an index of global corporate bonds, the Merrill Lynch data show. Canadian corporates have returned 0.5 percent in October, versus 0.2 percent on the broader index.

Provincial Bonds

Canada’s provincial bond market, with about C$458 billion ($447 billion) outstanding, yielded 52 basis points over federal benchmarks, from 53 at the end of last week and 58 at the end of September. Spreads were as wide as 71 basis points in May.

Merrill Lynch’s index of Canadian provincial bonds is up 0.3 percent this month, compared with a loss of 0.1 percent in its index of Canadian government bonds. An index of U.S. municipal bonds has returned 0.2 percent this month.

The Fed meets Nov. 2-3 and is forecast to say if and how it will implement a second round of quantitative easing, in which it creates money by buying securities.

Canadian resale home prices rose 11 percent in August from the same month a year ago, according to the median estimate of five economists surveyed by Bloomberg News. The Teranet-National Bank Composite House Price Index will be released at 9 a.m. New York time.

Treasury Comparison

Canada’s 10-year bond’s yield rose nine basis points, or 0.09 percentage points, to 2.83 percent, the highest in a month. The price of the 3.5 percent security maturing in June 2020 declined 76 cents to C$105.67. Canada’s 10-year bonds yielded 19 basis points more than equivalent-maturity U.S. Treasuries, the narrowest spread since Aug. 2.

Yields on the real-return bond index on Oct. 25 hit the lowest since Merrill began collecting the data in December 1995. Inflation bonds had their best three-month return since the first quarter of 2008 with a gain of 5.6 percent in the July- September period.

“There’s scope for break-even rates in the 10-year space to continue to rise,” said Mohammed Ahmed, a rates strategist with Canadian Imperial Bank of Commerce, adding that the price of the security would gain as a result. “A reasonable target is about 2.15 percent over the medium term. Inflation protection will demand a premium going forward.”

Inflation Expectations

Ahmed said inflation expectations, as measured by subtracting the yield on Canada’s December 2021 inflation-linked security from Canada’s June 2020 security, stand at about 2 percent, in line with the central bank’s inflation target.

The U.S. “are our biggest trading partner, so if there’s inflationary pressures in the U.S., there will likely be some resulting impact on Canada,” Ahmed said.

The Bank of Canada targets a rate of inflation of 2 percent and it’s unlikely the break-even will fall below that, making the purchase of real-return bonds a bet with more scope for gains than losses, he said.

Canada’s real-return bonds, which pay interest on principal that’s tied to the consumer price index, have gained 2 percent this month, compared with 2.9 percent and 1.2 percent for inflation-linked bonds in the U.S. and globally, respectively, according to the Merrill Lynch data.

To contact the reporter on this story: Alexandre Deslongchamps at adeslongcham@bloomberg.net;

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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