Friday 12 December 2008

Real Return Bonds Correlation and Current Prices

Reader Jordan posed a very good question in the comments of the previous post: " Does a real return bond have the same level of negative correlation to the stock market like short term bonds?" The answer in the research appears to be an emphatic No, they aren't like short term bonds in correlation to equities. The answer is even better!

Real return bonds are uncorrelated to both equities and other bonds. They are different enough to function as a separate asset class, which is exactly what the investor who uses asset allocation to manage his/her portfolio seeks.

ByloSelhi has an excellent page on RRBs; his links include a number of papers that have looked into this very topic. Bylo provides snippets of key conclusions to skim. For instance, the 2004 Kothari & Shanken paper says, "... We found that the real (inflation-adjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation among stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio."

Here's an eyeball version of non-correlation in this chart from Google Finance showing the iShares real return fund XRB plotted against the TSX, the iShares short-term bond fund XSB and the whole market bond fund XBB. It's only short-term (3 years or so) but one can see the lines don't follow each other closely.
The recent decline in price reflects the recent increase in yield to around the 2.5% level - see's current rates in the Real Return tab at the bottom of the page.

Buying an RRB with the intention of holding to maturity means that such price swings become irrelevant - the yield you get is that at which you bought - come hell (inflation) or high water (deflation).

With the yield difference between the regular Canada bond of 2025 maturity and the Canada 2026 RRB being only 3.79% - 2.64% = 1.2%, or the implied rate of inflation during that time, the RRB looks to be a good buy to me right now.


Jordan said...

Thanks for following up my question with great resources on real return bonds.

So would you suggest buying the real return bond directly or through the XSR even though it has a fairly high MER.

A commenter Phil S recently posted about Real Return Bonds on a guest post I wrote. Noting that they might not reflect real inflation. I've read very similar comments before that US TIPS (which I understand are equivalent to Real Return Bonds) have been subject to some manipulation to understate real inflation down there. Do you think this is a significant problem?

Jordan said...

Sorry I meant the iShares Real Return Bond Index XRB not XSR.

CanadianInvestor said...

I am a bit torn between XRB and individual RRBs. On the one hand there's no need for diversification to lower default risk by holding an individual Canada RRB and that saves the 0.35% MER on XRB, a significant number when RRBs are currently yielding about 2.5%. When holding the RRB long term, maybe even to maturity, the individual RRB is therefore much better. On the other hand, XRB permits rebalancing a portfolio much more easily and cheaply than holding just one RRB. You would need to have very large amounts in a portfolio to make the buy-sell spread (which is how the dealers get their commission) reasonable on rebalancing trades of one RRB - e.g. the min purchase is usually around $5k.

So far I've only bought an individual RRB (prov of Quebec 01Dec2021) but I intend to replace more of my bond ladder with some Canada RRBs) and not buy any XRB. I intend to hold them forever. I am hoping the rebalancing I will have to do will mean buying more not selling - if equities recover I should be ok.

Re inflation, I've seen comments that government inflation numbers are suspect, a prime and visible proponent being It is on my list of "investigate and post" but I don't know for sure either way. Don't know either if TIPS and /or Canadian RRBs have any special extra restrictions that result in an investor not even getting the full official CPI. Have you seen that? If so, any sources? For now I am taking the attitude that they are better than nothing.

Finally I don't see a reason to buy US TIPS instead of just Canadian RRBs. Maybe if one has significant US spending to do it's good to have USD. Otherwise, one is just adding in exposure to exchange rate risk. The equity side of an internationally diversified portfolio usually already has lots of that so more isn't desirable.

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