Aug. 20 (Bloomberg) -- Investors profiting from the record rally in Canadian inflation-linked bonds risk running into the one thing they haven’t counted on: deflation.
Linkers, whose principal and interest payments rise with inflation, have gained 14 percent this year, and beaten real-return bonds from the U.S. to Australia, Bank of America Merrill Lynch index data show.
With consumer prices from July forecast to decline, investors may be less inclined to purchase the securities because any adjustment in the coupon payments made to offset gains in inflation will likely be lower than in prior months, according to RBC Capital Markets. Bids at today’s auction of C$400 million ($365 million) of real-return bonds due 2047 exceeded the amount offered by 2.49 times, below the three-year average of 2.73 times.
“The fact that CPI is being released Friday makes setting up for the auction more tricky,” Ian Pollick, senior fixed-income strategist at RBC, said by phone from Toronto yesterday. “If you buy the bond, inflation accruals will be smaller than they were the previous months.”
July inflation is expected to show a drop of 0.1 percent from the previous month, the first negative report this year, according to the consensus forecast in a Bloomberg survey.
Consumer price gains exceeded the Bank of Canada’s 2 percent per year target in May for the first time in more than two years, an unexpected acceleration led by energy costs, Statistics Canada said June 20 from Ottawa.
The consumer price index rose 2.3 percent following April’s 2 percent gain, belying the central bank’s April 16 prediction that inflation will return to its target in the first quarter of 2015.
That helped Pacific Investment Management Co. erase 2013’s losses on its fund dedicated to Canadian linkers. The Canadian Real Return Bond Fund is up 13 percent this year through July 31, offsetting a similar decline in the 12 months ending Dec. 31, according to the money manager’s website.
Signs that appetite for inflation-linked notes is waning were evident in the last auction on June 11, which garnered a bid-to-cover ratio that was below average at 2.513 times, according to RBC. In general, participation in Canada’s government bond auctions is declining to the lowest level in at least two years as foreign banks including Deutsche Bank AG and Morgan Stanley avoid the sales.
Tepid inflation from the U.S. to the U.K. and Germany is threatening to slow economic expansion. In the U.S., inflation cooled to the lowest in five months yesterday at 0.1 percent in July. In Britain, a statistics office report yesterday showed consumer prices fell by a sharper-than expected 0.3 percentage point from June.
For Bank of Canada Governor Stephen Poloz, who has cited persistently low inflation as one of the biggest drags on economic growth, the setback will provide more justification for extending a four-year pause in rate increases.
“Poloz seems to be an easy-money kinda guy,” Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management LLC, which oversees $45 billion, said by e-mail yesterday. “We’re in an OK growth/low inflation environment, which means that central-bank policy will be skewed toward further easing.”
While Canadian inflation-linked notes look less appealing, investors can minimize losses holding longer maturities like those on auction today, Pollick said. Assuming RBC’s forecast for a drop in July inflation materializes, investors in real-return bonds due in 2021 face a carry cost of negative 2.3 basis points through November, while holders of 2047 maturities could earn 0.2 basis point, he wrote in a note to clients published Aug. 18. A basis point is 0.01 percentage point.
McIntyre, who exited all his Canadian investments in January 2012 and boosted his holdings in Mexico, doesn’t regret the decision.
“Wish I could tell you that we fell in love with Canada, but I’d be lying,” McIntyre wrote yesterday. “We have no exposure, long or short to Canada.”
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