Friday, 9 May 2008

A Worthwhile Investment: Real Return / Index-Linked Bonds

An investment portfolio is like a house. It may be complete and look fine overall but there is always some improvement to be done. In my investment portfolio, the next renovation project will be to rip out some of my regular fixed income and install some real return bonds. Here's why I'm going to do it and how. I think it's something everyone should do, much like a kitchen renovation, since it always adds value.

What are Real Return Bonds (RRB)?
To quote Bylo, whose primer Real Return Bonds for Canadian Dummies I highly recommend (many of the links cited below I found at his website),
"Real Return Bonds (RRBs) are Government of Canada bonds that pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation."
Their other name, often used in other countries - index-linked bonds - comes from the fact they are linked to an inflation index like a CPI (Consumer Price Index). Both the principal and the coupon aka interest payments go up with inflation. Another excellent brief description of inflation indexed bonds, with reference to the US version called TIPS is in the Investopedia article titled Inflation-Protected Securities - The Missing Link.

Inflation-adjusted Interest vs Real Yield
It is important to keep straight that there is difference between the inflation-adjusted coupon interest return and the real yield return you get when you buy the bond on the market. When you buy some of the Canada RRB maturing Dec 1st, 2021 with a 4.25% interest coupon (set in 1991 at original issue), you do not receive 4.25% as the real return on your investment, nor do you receive that as the cash payment of interest every six months on June 1st and December 1st.
  • Real yield: supply and demand in the market sets the yield through changes in the price you have to pay for the bond. For instance, the price quoted (at the time I looked it up) on in the Real Returns tab in the bottom panel of the page showed that the current real market price of $130 for every real $100 of bond works out to a real yield of 1.75% per year. You can check the recent real prices at the bottom of this Bank of Canada web page .
  • Inflation-adjusted cash payment: the Bank of Canada publishes here the inflation adjustment factor to multiply times the interest coupon. It changes every day as inflation marches on, slowly or quickly. For May 9, 2008, the factor is 1.35179. The semi-annual interest payment is notionally 1.35179 x (4.25% / 2) = 2.8726% though it is only paid on June 1st when the inflation factor will be 1.35537. The holder of $1000 face value of this RRB will receive interest of $1000 x 1.35537 x (4.25% / 2) = $288.02.

That 1.75% sounds pretty low compared to other government of Canada bonds seen on the same page at around 4% but those other bonds will not be adjusted for inflation by the government and so the expected inflation rate is factored into the price, i.e. about 4 - 1.75 = 2.25%. If inflation is actually lower over the next 13 years than 2.25% then the RRB is not as good a deal but if it is higher than that the RRB wins.

In retrospect, we should have loaded up on RRBs ten years ago when the real yields were 4%! The Bank of Canada publishes data on the real yields of the federal government RRBs back to 1998. Yields have drifted steadily downwards ever since 1998. The average during 1998 - 2008 is 2.94% and the last time it was 3% was 2003. Another BoC page shows yields in recent months and illustrates the fact that fairly significant changes can occur in a few months - it was up to 2.2% last June/July.

What would it take to send yields back up to 4+%? Frankly, I'm not sure but the period when yields were highest was during higher inflation in the 1990s.

Why Own Them in a Portfolio?
  1. Inflation-protected interest and principal - for those who want or need cash flow and principal, e.g. for income in retirement, guaranteed to be free of inflation risk and default risk (is the Government of Canada likely to default on repayment in 2021?) RRBs are a godsend. A big risk with long term nominal bonds is inflation since higher rates, over and above what is assumed and built into the nominal rate, can destroy the principal value of long term fixed income investments as surely as default. RRBs are a superb tool for capital preservation if held to maturity. Meantime, the cash flows are automatically increased for inflation so your purchasing power is conveniently maintained. Back in November 2007, journalist Jonathan Chevreau published this interview with finance prof and author Zvi Bodie who strongly believes in RRBs. As inflation threatens again to start accelerating, the value of RRBs is rising.
  2. Asset class diversification benefits - RRBs have the wonderful property of being uncorrelated or even somewhat negatively correlated with regular fixed income, equities and real estate, as well as Canadian currency fluctuations vs the US dollar. See the Altruist Financial Advisors Reading Room page listing of articles under the heading Inflation-Indexed Bonds for the academic research that demonstrates these effects. The diversification benefit refers to the opportunity to lower the overall volatility i.e. risk, of a portfolio through including RRBs. One of the studies in the list - TIPS As An Asset Class by Peng Chen and Matt Terrien - (TIPS are the US version of RRBs) concludes that "TIPS offer investors an option for portfolio diversification that no other instrument can replicate. ... For investors with most of their portfolios invested in traditional financial assets, the inclusion of TIPS reduces the risk and increases the return of the entire portfolio."

How to Fit Inflation-Indexed Fixed Income into the Portfolio
  • the research studies indicate that RRBs should replace a portion of normal bonds, especially the longer maturities; this makes sense given that RRBs themselves are long maturity bonds
  • the exact proportion of normal bonds vs to hold is not a single number; at Libra Investment Management these calculations show that the RRB allocation can be anywhere from 15% up to 100% of fixed income and the previously cited TIPS As An Asset Class study indicates it should be most of the fixed income allocation in the portfolio.
  • since RRBs are taxable as interest, which attracts the highest tax rate (see the description of the tax treatment in the Prospectus at the BoC), RRBs should be held in a tax-deferred registered account like an RRSP, RRIF, LIRA etc
The Mechanics of Buying
Bylo's previously mentioned webpage neatly describes the choices. The only thing to add is that in Canada there are not many offerings to choose from. The Government of Canada has five series outstanding:
  • 4.25% 01Dec2021
  • 4.25% 01Dec2026
  • 4.00% 01Dec2031
  • 3.00% 01Dec2036
  • 2.00% 01Dec2041
The Dec2041 issue seems not to be quoted on the Canadian Fixed Income site and may not be readily available. Similarly, bonds from the Quebec, Ontario and Manitoba governments may not be available. Phone the bond desk of your broker to find out what they have. The provincial RRBs will yield slightly more than the federal ones. It doesn't really matter as it is not necessary to hold more than as the default risk is not an issue.

In calling my broker, the minimum purchase amount was indeed $5000, not the $1000 the Bank of Canada prospectus says (in the secondary market where you and I trade, the BoC's prospectus rules do not apply).

The biggest issue with buying them now is the low yield. Between the time I looked up the current rates and the end of the day on Friday, the yield on the Canada 2021 issue had fallen from 1.75% to 1.68%. That's the mid-market rate, halfway between the buy and sell. Factor in the higher price (meaning a lower yield to you) from the broker and the real return is even lower. It's a tough choice between holding off and waiting for a better rate in the 2% range or going for the diversification benefits now.

A quick follow-up note - found this Bank of Canada research paper World Real Interest Rates: a Global Savings and Investment Perpsective, which concludes that low real rates are a global phenomenon and that changes occur slowly over years. From their graph on page 2, it would appear a 1% shift in a year is about the most that could happen.

Since the real rate is driven, according to the paper, largely by the balance of global investment vs savings, if we are in a period of economic slowdown, what are the chances of a resurgence in the real rate soon?


Anonymous said...

Good post on a topic that doesn't get enough airplay.

I have XRB (iShares real return bond etf) for my allocation.


Anonymous said...

Great post. I’ve found your article very useful since I am browsing blogs and trying to find some serious information bout Real Return Bonds. I working as a Vancouver real estate
agent and significant part of my portfolio was linked to the real estate. Real estate market has become more volatile than even before so I am seriously thinking to secure my portfolio with RRB. I have found also many kinds of certificates which are I think the best what you can get on the financial derivates market.

CanadianInvestor said...

Vcr realtor,
nice houses you sell! I am intrigued by your comment re certificates that you can get on the derivatives market. Care to elaborate on what they are and what they do for you?

Piazzi said...

all this is good if you assume government reporting of inflation is truly reflective of the devaluation of money. That is a big assumption to make

CanadianInvestor said...

piazzi, I've seen comments doubting the accuracy of government inflation figures and a quick Google search brings up a number of posts and web comments along those lines. Governments do have an interest in keeping down inflation so publishing numbers that show it lower than reality might not be impossible. Governments have been known to tell little white lies now and then. It worries me when politicians start to say price rises are "one-time price adjustments" and not inflation. Thanks for a blog post idea. Will have a look into this for a post.

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