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Inflation Is Back: Should You Buy Real Return Bonds?

For bond investors, the rate of inflation is a critical factor in determining if a bond or a guaranteed investment certificate will be a winner or a loser. Buy a bond or a GIC that pays less than the rate of inflation, and you are on the losing side of the deal. Beat inflation and then handle taxes, perhaps by keeping bonds or GICs in a registered plan like an RRSP or a Tax-Free Savings Account, and you can be a winner with little downside risk.

The economic recovery that appears to be underway implies a return to the good old inflation everybody knows. The Bank of Canada has set a target rate of inflation that would see the Consumer Price Index rise at 2.0 per cent per year. The BoC is thought to be comfortable with a CPI increase rate of 2.5 per cent.

Inflation is picking up. The CPI, which rose at an annualized rate of just 0.9 per cent per year in the fourth quarter of 2009, should rise to an annualized rate of 2.1 per cent by the fourth quarter of 2010 and maintain that rate for another year, according to the economics department of the Bank of Nova Scotia.

There are two ways to handle inflation in a fixed income portfolio — you can buy a bond that, you hope, has a return higher than the inflation rate. Or you can buy a Real Return Bond that bases its payouts not on interest rate changes, but on changes in the Consumer Price Index.

The math on RRBs is straightforward. The bond market has recently offered the June 1, 2037 conventional Government of Canada bond with a yield to maturity of 4.00 per cent. Or you can buy the Dec. 1, 2037 Canada Real Return Bond with a yield to maturity of 1.55 per cent. The difference in yields is the expected rate of inflation, which is 2.45 per cent. That’s right on the Bank of Canada inflation target.

In this case, the RRB will pay 1.55 per cent plus the CPI increase, which the bond market predicts is going to be 2.45 per cent per year for the next 27 years. Or, if you look at it the other way, the conventional bond will pay a real return (that’s the nominal return less inflation) of 2.45 per cent.

If inflation runs over 2.45 per cent for a long time, the RRB will be the winner. If inflation is less than 2.45 per cent, the conventional bond wins.

What to do? First, let’s be honest about long-term economic predictions — they are tentative at best. But inflation is a fact of life and buying some protection against it is not a bad idea.

RRBs have had a terrific year. For the 12 months ended Dec. 18, 2009, Real Return Bonds produced a 15.1 per cent return. That beat risky emerging markets bonds, which produced a 14.0 per cent return for the same period.

There is some bias in the numbers. Back in late 2008, investors were worried about deflation. Real Return Bonds can actually produce a negative return if the CPI goes down, so investors sold RRBs off and their price collapsed. With the return of inflation, RRB prices are up and their gains have been spectacular.

For the next few years, there is a good chance that the CPI could rise at a little more than its expected 2.5 per cent annual rate. Rémi Roger, vice-president and head of fixed income at Seamark Asset Management Ltd. in Halifax, N. S., notes that the recession has left the federal government, which is the principal issuer of RRBs, with a deficit that will last for perhaps five years. To make up for diminished tax revenues, the government will issue more bonds. To sell them, it will put Canada’s federal debt on sale. Bond prices will drop, including prices of any new issues of RRBs. You will be able to buy the income flow from RRBs or from conventional bonds at a discount. That has to be a good deal.

In this scenario, as inflation picks up its pace, pension funds will scoop up the inventory of RRBs, pulling up their prices. So you’ll be able to buy cheap and hold for a higher price down the road. This is, of course, a best-case scenario for RRB investors. But if inflation rates were to drop, RRB prices would slump, pension funds would sell RRBs and ordinary rank and file RRB investors could take losses. There is always risk.

We need a word of caution here. RRBs are easily bought from investment dealers or through various mutual funds and specialized exchange-traded funds. There are very few issues of RRBs and inventory is always tight. The most efficient way to buy RRBs is through a mutual fund, such as the TD Real Return Bond Fund, which generated a 20.7 per cent gain for the 12 months ended Dec. 30, 2009. The TD fund has a management fee of 1.42 per cent and a minimum purchase of just $100. You can also buy RRBs through an ETF like Barclays iShares RRB fund, symbol XRB. In 2009, it produced a 17 per cent return net of its relatively low 0.35 per cent management fee. RRBs are all government issues. They are AAA credits and present almost no default risk.

But there is a tax problem. RRBs adjust their payouts by raising their capital base in line with the rise of the CPI. But rather than taxing growing capital as a capital gain, the Department of Finance dictates that these gains be taxed as income. As a result, RRBs held in cash accounts create accounting headaches and lead to high tax bills.

But held within registered plans like RRSPs and TFSAs, they present no accounting problems and work beautifully.

Bond dealers are take-no-prisoners capitalists. Try to pick up some scarce RRBs from them and you will be competing in a tight market with big pension funds. Guess who gets the better price? So going with a mutual fund that focuses on RRBs or the iShares ETF is smart.

With a managed RRB portfolio, you get liquidity and you can sell any day.

You get price visibility, which is a little harder with the actual RRBs that are traded over the counter like other bonds. The ETF is just a cheap way to invest and a managed fund, like the TD RRB fund, can beat the index with some shrewd manoeuvring, adjusting average maturities and targeting specific periods of inflation.

As Yoga Berra once said, “making predictions is hard, especially about the future.” In the bond market, an investor not only has to make interest rate predictions, but he has to beat professional investors. Even so, having some RRB exposure to uncertain CPI changes is not a bad idea. Putting, say, 10 per cent of your fixed income money into RRBs could provide downside protection if inflation rises. Deflation would hurt RRBs, which would have falling payouts, though conventional bonds with fixed coupons would thrive.

Deflation is not a likely scenario. More inflation is. Go for a little RRB exposure, check this advice with your investment adviser, and be guided by your wisdom.

Andrew Allentuck is author of Bonds for Canadians, published by John Wiley & Sons in 2006.

About the author

Columnist

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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