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Real return bonds
Recent interest a little late

The expectation of rising interest rates over the past couple of years has generated interest in real return bonds (RRBs). Strong returns in what otherwise was a bear market from 200-2003 also turned a few heads. I like and have recommended real return bonds in the past, but the current fascination strikes me as 'too little, too late'.

Yield history and price drivers

RRBs were first issued in 1991 at a yield of 4.25 percent on top of inflation. In 1995, the yield surpassed 5 percent and spent much of that year flirting with that level. Spring 2003 saw RRB yields dip below 3 percent annually for the first time and it has been falling ever since. Currently, RRB yields are running just north of 2.3 percent after rising slightly.

Changes in the yield on long-term Government of Canada bonds have a strong influence on RRB returns. This makes sense since RRBs in Canada have always been long-term bonds. Given that the first RRB issue matures in the year 2021, they will become less and less sensitive to longer rates. Newer issues, however, have a term to maturity of more than 30 years.

Embedded in the yields on long-term Canadas are future long-term inflation expectations, which is built into what the bond market decides RRBs should yield. So, more specifically, RRB prices (and returns) are really driven by what the market feels RRBs should yield.

Supply and demand also play a significant role here since pension plans and other institutions with liabilities related to inflation are big holders of RRBs. A relatively smaller source of RRB demand is the mutual fund industry, which until recently had only one dedicated RRB fund. Today, four mutual fund offerings - from Mackenzie, Renaissance (CIBC), SEI, and TD (the original) - emphasize or are dedicated to RRBs.

During shorter periods, changes in inflation expectations or unexpected inflationary changes can also result in RRB price volatility. The U.S. government offers its own version, called TIPS (Treasury Indexed Participation Securities).

Also, RRBs won't necessarily protect against quickly rising rates, such as occurred in 1994. According to figures compiled by BC-based Libra Investment Management Inc., RRBs lost 14 percent during calendar 1994, nearly double the loss of conventional long Canada bonds. While 1994 is remembered for a 400 basis point rise in short term rates, it also saw longer rates back up significantly. During that year, long Canada bond yields rose 185 basis points while RRB yields backed up 114 basis points. RRBs are long term bonds, hence the significant price decline. Not coincidentally, RRB yields peaked shortly after this time.

Past RRB recommendations

While I had previously written about and recommended RRBs, my first mention of them that remains in the public domain is in this 2001 article. The article contains both a basic explanation of the bonds and a link to a more in-depth paper on the bonds from the Bank of Canada.

My general rule has long been to split bond exposure into three equal pieces: high yield, RRBs, and other investment grade debt. I continue to consider RRBs as important diversifiers and a great inflation hedge. However, investors today must be aware of valuation issues.

RRB valuations

While I still like the general rule noted above, I am hesitant to load up on RRBs today given the significant drop in real yields (i.e. spike up in valuations) over the past year. At 2.3 and 2.1 percent, respectively, RRBs and U.S. TIPS are at all time lows (albeit during their short histories). However, conventional bonds are also sporting historically low yields.

The North American bond market's expectation of future inflation over various future time frames has risen substantially over the past year to between 2.3 and 2.7 percent depending on the time horizon. This is an increase over what prevailed in the late 1990s but still significantly below expectations of a decade ago.

I have advised clients to hold (and not sell) existing RRB positions, but not to add to them at this point. The reasoning in those cases was that the RRBs were meant as a longer-term portfolio hold that will eventually provide an indexed income during retirement. In a portfolio context, RRBs continue to possess unique benefits. However, they're no longer cheap. And since they are not entirely immune from rising rates, they should be included in the context of prudently diversified investment policies.

Finally, I've had a number of questions on the RRB mutual funds. I don't recommend any of them at their current fee levels, which start around 1.6 percent and go toward 2 percent per year. Those fees eat up the real yield offered by RRBs. In my opinion, buying RRBs directly is the only way worth including them in portfolios.



Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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