PrefBlog

The C.D. Howe Institute has taken a very ill-advised leap into bond market commentary with its publication Cancel the RRB Cancellation by William B.P. Robson and Alexandre Laurin. The basic thesis is similar to that of all welfare bums: the goal of government financing policy should be to provide interesting products to investors:

The government’s cancellation of the RRB program means that Canadian savers will have less access to a uniquely valuable tool to protect themselves from inflation. The pension funds and other institutions that invest on individual Canadians’ behalf will lose a key tool to help them deliver on their promises.

To their credit, they acknowledge the liquidity problem with RRBs, but their prescription – basically, mirror the nominal market in terms of term diversification, increase issue sizes – has a major hole in it: it ignores the fact that any dummy can eliminate the excess liquidity premium paid on RRBs, instantly, certainly and cheaply by … issuing nominals instead. Bang. Done. Did.

The case for issuing RRBs in the first place rests on a decomposition of nominal yields into three basic parts (there are, of course, lots more influences, but three will suffice for now):

• Real Yield
• Inflation Compensation
• Inflation Compensation Risk (the risk that you’ll be wrong when assessing how much inflation compensation you need)

The presumed attractiveness of RRBs is that by offering certainty on the Inflation Compensation part, the government can capture the Inflation Compensation Risk part and thereby reduce its financing costs. RRBs are not my field, but I don’t believe that this has ever happened with any such programme anywhere – if I’ve got this wrong, let me know in the comments, and let the BoC in on it too, as they’ll be happy to learn something new.

RRBs cost more to issue due to a liquidity premium on yield relative to nominals. Since the Inflation Compensation Risk Premium does not exist, or cannot be captured, or is captured to such a tiny extent that it’s not measurable, there’s no point in issuing RRBs. QED.

This entry was posted on Thursday, August 22nd, 2024 at 8:37 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.