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How To Pace Inflation

In the business of keeping up with inflation, there is nothing simpler nor more guaranteed to work than a Government of Canada Real Return Bonds (RRBs). They have been in use for several decades and, though complex in their operation, they do the single job of making sure what they pay and what they are worth are in perfect synch with increases in the consumer price index.

RRBs have also been a hot investment. For the 12 months ended January 31, 2010, mutual funds holding RRBs generated a 17.53 per cent gain compared to a relatively modest 9.16 per cent gain for mutual funds that hold conventional bonds. The difference in performance is due to perceptions back in January, 2009 of where the world economy was headed.

Doom was the prevailing outlook. Markets were tumbling. The outlook was for deflation. That put a premium price on ordinary bonds, for their fixed interest payments would have increasing buying power if the CPI were to decline. But RRBs were in the opposite situation. RRB payouts would go down if the CPI declined. So RRB prices were falling and, for a few weeks, it was possible to buy a return in an inflation-protected bond (that’s the RRB) — for less than what the same return cost in a plain vanilla bond.

We are still in a recovery, even if it seems feeble down on Main Street. Investors who want a rock-certain promise of future income, nothing beats Government of Canada bonds. There is no foreign currency risk, no credit risk and the only issue outstanding is what interest and the eventual return of capital will be worth.

REGULAR VS. REAL RETURN BONDS

An investor with a retirement to finance can buy a conventional Government of Canada bond, such as the 5.75 per cent issue due June 1, 2029 and currently priced at $122.76 per $100 face value to yield 4.04 per cent to maturity or the Government of Canada five per cent issue due June 1, 2037 currently priced at $1,16l.10 to yield 4.02 per cent to maturity.

The alternative is to buy a Government of Canada RRB such as the four per cent issue due Dec. 1, 2031 currently priced at $145.96 per $100 face value to yield 1.51 per cent per year to maturity or the three per cent due Dec. 1, 2036 currently priced at $131.81 to yield 1.54 per cent per year to maturity.

You might think that only a person who hasn’t got all his grey matter working would take an RRB over a conventional bond, but that would be wrong. The two bond payment rates post-inflation are actually very close. Subtract the RRB yield of about 1.5 per cent from the long Canada bond yield of four per cent and you get 2.5 per cent, which is the implicit long term inflation forecast for Canada and, one might add, what inflation has averaged for a couple of decades.

That is just forecasting averages. If the question becomes “which is the best deal right now,” then you have to adjust not for average historical inflation but what the market says is happening today. We remain in recession, so the outlook for consumer price index changes is modest. The Bank of Canada forecasts a 1.7 per cent rise in the CPI in 2010 and a still sub-normal 2.10 per cent rise in 2011. So let’s use the 1.7 per cent number. Add that to the 1.54 per cent number for the 2036 Canada RRB and you get an average annual return of 3.24 per cent, which is a lot less than the 4.02 per cent return to maturity of the June, 2037 bond.

And it really does make a difference.

Buying the RRB would turn $100,000 on a pre-tax basis into $229,112 in 26 years. The conventional bond that pays fixed interest would turn into $278,636 in the same period. The difference is $49,524 — not chicken feed by any means.

But there is more to the choice than just the higher return currently available from the conventional bond — the issues are what the real market will do, what inflation may do in future and tax issues.

In the real market, investors should watch the trading done by the biggest buyers of RRBs. Pension funds love them, for they provide automatic indexation of pension benefits that must be paid. Moreover, with the Government of Canada having been able to reduce outstanding debt, long bonds of all kinds got to be scarce. RRBs gained in price just on a supply and demand basis. The Bank of Canada may issue more RRBs to help pay for the fiscal deficit expected in 2011 and 2012 but, offsetting that, pension funds with more obligations to cover due to an expanding labour force may bid up RRB prices even more. If the quantity of RRBs demanded jumps faster than the supply hitting the market, RRB prices will rise and continue their strong performance.

Or vice-versa.

Inflation has been quite low. On a current inflation-priced basis, the conventional bond wins. But if inflation picks up and rises over 2.5 per cent for an extended period, RRBs will be winners.

TA XCONSIDERATIONS

There is the final matter of taxation. RRBs are taxed twice each year. First, the interest paid out is subject to tax as income. Second, because RRBs boost their price base in order to make their initial payments of 1.5 per cent of face value, each year’s boost in payout results from what amounts to a capital gain. The Canada Revenue Agency views the increase in the base price as income too and taxes it at the highest rate as income. The investor in RRBs could be said to be prepaying his future tax bill. In reality, he is being whacked twice as hard as the holder of the conventional bond who is only taxed each year on interest received.

The solution is to hold RRBs in RRSPs or in Tax-Free Savings Accounts where annual taxation simply does not happen or matter. These complex bonds are also immune from current taxation in Registered Education Savings Plans. When the money from RRSPs and RESPs is distributed, gains over initial cost are taxed as income. In TFSAs there is no tax on payout at all.

Which to buy? Over time, the advantage on holding a low return bond goes to the low fee ETF. But in periods of rapidly changing economic outlook or dramatically changing interest rates, actively managed funds can outperform ETFs.

Andrew Allentuck is the author of When Can I Retire? Planning Your Financial Life After Work, published in 2009 by Penguin Canada

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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