Introduction
Inflation is the exposure in an institutional portfolio that compounds against investors with certainty: In the absence of a market event, a credit cycle, or a liquidity squeeze, inflation can still erode portfolio returns. It simply accrues – negatively – and impacts a key metric the long-horizon investor is keen to protect- purchasing power.
Canadians had a vivid reminder of inflationary pressure this decade: Consumer price inflation peaked at 8.1% in June 2022, the fastest annual increase since January 1983.1 Since the start of 2020, Canadian consumer prices have risen by around 24%, so a dollar set aside at the beginning of the decade now buys around 76 cents worth of goods in 2020 terms.2 Headline inflation has since come back down to 2.8% as of June 20263, but is still above the 2% target set by the Bank of Canada.
But even if it were to return to target, the problem of eroding purchasing power remains. For an institution with obligations measured in decades, the target itself is the problem. At the Bank of Canada’s 2% objective, a dollar loses half its purchasing power in about 35 years.4 At the 2.8% rate recorded this June, it takes about 25 years. A pension plan providing benefits into the 2060s, or a family office thinking in generations, is not principally exposed only to whether inflation spikes again: It maintains latent exposure based on the math of compounding interest.
That makes inflation resilience a core portfolio construction component rather than a tactical one, and it is precisely where Canadian asset managers should be focusing. In discussions with Canadian pension plans and family offices since 2022, we keep hearing a version of the same refrain: “We know that our liabilities depend strongly on inflation, but we are not sure what hedges them best.”
This stems from the fact that the first purpose-built instrument for hedging inflation in Canada no longer exists. The Government of Canada stopped issuing Real Return Bonds (RRBs) in November 2022, citing poor demand.5 Leading up to the discontinuation, the market for RRBs was modest and thinly traded: roughly $65 billion of outstanding notional just prior, representing only about 2% of Canadian bonds on issue, against 6% in the US and 22% in the UK.6 Every year the remaining stock of RRBs rolls down with some bonds expiring as time lapses. Thus, the benchmark investors measure themselves against has become ever less investable and meaningful.
In the absence of a specific instrument to address inflation-driven erosion, the real challenge is what strategy to deploy in a portfolio to help it hold its real value and therefore its ability to keep investors purchasing power steady over time.
This document explores how, with the encouragement of our clients, we developed the Validus Inflation Resilient Bond Strategy (IRBS), what the empirical evidence says about its effectiveness and that of the remaining alternatives and an overview of how IRBS is constructed.
Why not just buy TIPS?
The simplicity of the arguments put forward in support of building inflation resilience through TIPS can be appealing at first glance. Canadian and US headline CPI have been close to 80% correlated since 1982, and the TIPS market is deeper and more liquid, while offering a full maturity curve.
But correlation is not causation. The two series are produced by two economies with different structures, different policy settings and materially different CPI baskets; i.e., shelter, personal care, and particularly in healthcare. A strong correlation only suggests they move in tandem most of the time but does not provide any visibility into their differential.7 The year-over-year gap between Canadian and US inflation has swung by roughly three percentage points in both directions at various points in time since 1982.8
Furthermore, the risk posed by price variations rather than the difference in CPI should not be underestimated. A Canadian investor holding TIPS is exposed to the difference between two yield curves, not just the difference between two inflation rates. That exposure was quite stable for decades, before breaking down abruptly. Between May 2024 and mid-January 2025, a maturity-matched portfolio of US TIPS underperformed the Bloomberg Canada RRB index by 5.1%, driven mostly by a widening long-end rate differential that reached 140 basis points.9 Currency hedging costs widen the tracking error further.10
TIPS hedge US inflation well as that is what they were built to do. They were not engineered to hedge Canadian inflation, so, Canadian investors looking to address inflation should be wary of the risks of using an instrument that is not fit-for-purpose.
Do real assets do the job?
Another approach often adopted to address inflation risk relies on real assets, with the largest pension plans increasing allocations significantly in the last decade. Here is what we found when we stress tested an inflation resilient strategy based on real assets: Using quarterly returns from 2004 to 2022, we regressed price changes of each asset class against the excess return of TIPS over maturity-matched nominal bonds, to get a clear picture of their relationship with real yields and relevance to inflationary hedging .12
The results were not uniform. REITs showed a weak and statistically unconvincing link to CPI, though we found a better relationship with break-evens. Commodities came through strongly on both tests – unsurprising given how firmly they are rooted in the inflation process. Infrastructure was the surprise; while correlated with CPI on a two-quarter lag, there was effectively no relationship to break-even rates at all. The takeaway is that real assets – except for commodities – have either no real inflation hedging benefits or have a wide basis of risk. One can conclude that implementation of a real assets’ strategy as a hedge to inflation has very limited merit.
Constructing the exposure directly
A more precise approach starts by considering what an inflation-linked bond actually is. One can rigorously demonstrate that it can be decomposed into a nominal bond plus a long position in realized inflation over that bond’s life. That is the basis of the Validus Inflation Resilient Bond Strategy. A custom-made CPI hedge basket is paired with a portfolio of nominal bonds, and the two are rebalanced as a function of the inflation regime changes. No discretionary market timing, no leverage.
This innovative construction is designed to do two things at once: capture the increase in Canadian CPI through the hedge basket and mitigate the mark-to-market drawdowns a nominal bond book suffers in a rising rate regime. Because the pairing is modular, the strategy can be applied to a bond portfolio of any duration or type, including provincial bonds, which Canada never issued in “real-return” form.
What it means for the portfolio
What an investment team gets from the Validus IRBS is a flexible, liquid and scalable strategy to help manage and counter the negative effects of Canadian inflation. This solution does so without taking on any US interest rate or currency risk.
In sum, IRBS is a Canadian solution for a Canadian specific risk.
This strategy is suitable for any investment portfolio and not just those used to hold Real Return Bonds. Any institution with liabilities or a mandate defined in real terms and all investors wary of purchasing power erosion face the prevailing compounding arithmetic, which inevitably works against them over time.
The IRBS has a natural place in the fixed income sleeve of a well-constructed portfolio. Allocating 8% to 12% to this inflation resilient bond strategy – in the context of a balanced portfolio – aims to have both inflation hedging and accretive effects over the long term.
Sources and Notes
1. Statistics Canada, Consumer Price Index, June 2022. The 8.1% year-over-year increase was the largest since January 1983.
2. Validus Risk Management calculation from Statistics Canada Consumer Price Index data, January 2020 to June 2026. Cumulative price growth over the period is approximately 24%, so a dollar set aside at the start of 2020 buys around 76 cents today.
3. Statistics Canada, Consumer Price Index, June 2026.
4. Bank of Canada inflation-control target of 2%, the midpoint of the 1% to 3% control range. Halving times are Validus Risk Management calculations: at a constant 2% rate purchasing power halves in 35.0 years; at a constant 2.8% rate, in 25.1 years.
5. Department of Finance Canada, Budget 2022, announcing the discontinuation of Real Return Bond issuance, citing low demand. Final auction November 2022.
6. Validus Risk Management research, January 2024. Real Return Bond stock outstanding of approximately $65 billion prior to discontinuation, and index-linked securities as a share of domestic sovereign bonds on issue of approximately 2% in Canada, 6% in the United States, and 22% in the United Kingdom.
7. Validus Risk Management analysis, January 2024, of Statistics Canada and US Bureau of Labor Statistics headline CPI, 1982 to 2022. Average correlation between the two series is close to 80%; the slope of the regression of Canadian on US CPI is 0.77. Basket composition differences are drawn from published Statistics Canada and Bureau of Labor Statistics CPI weights.
8. Validus Risk Management analysis of Statistics Canada and US Bureau of Labor Statistics headline CPI, 1982 to 2022.
9. Validus Risk Management analysis, February 2025. Maturity-matched US TIPS portfolio versus the Bloomberg Canada Real Return Bond index, May 2024 to mid-January 2025. The Canada to US long-end yield differential reached 140 basis points in January 2025.
10. Validus Risk Management analysis, January 2024. The cost of hedging USD/CAD exposure over the life of the position adds to tracking error against a Canadian real return benchmark.
11. Ontario Teachers’ Pension Plan, 2023 Annual Report, liability hedge portfolio allocations. The remaining allocations are nominal bonds (35%), natural resources (5%), and other inflation hedges (5%).
12. Validus Risk Management analysis, May 2024. Quarterly returns from 2004 to 2022, regressed against year-over-year changes in CPI and against the excess return of inflation-linked bonds over maturity-matched nominal bonds. Asset classes are represented by US dollar benchmarks, which offer the longest consistent histories for these sectors, and are regressed against US CPI. The findings describe how these asset classes respond to inflation as a class; they are not a measurement against Canadian CPI.
