Hidden Pitfalls of Real Return Bonds

04/27/2011 9:45 am EST

Focus: GLOBAL

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Canadians who want to shield their investments from the threat of inflation probably won’t find that protection in real return bonds, writes John Heinzl, reporter and columnist for GlobeInvestor.com.

With gas and grocery prices going through the roof, investors are increasingly nervous about inflation. So now must be a great time to buy real return bonds, right?

After all, the whole point of RRBs is that they protect your nest egg from inflation.

Well, not so fast. Today we’ll take a close look at real return bonds. What are they? How do they work? And why do some fixed-income experts advise investors to steer clear of them?

What Are Real Return Bonds?
RRBs are issued primarily by the Government of Canada and a few provinces. The unique thing about RRBs is that the principal and interest payments rise with inflation, preserving your purchasing power.

For example, consider an RRB issued at $1,000, with a fixed semi-annual coupon of 2%. Assuming no inflation, the bond would pay interest of $20 every six months.

However, if the consumer price index were to rise 1% in the six months after the bond is issued, the principal would be adjusted to $1,010 ($1,000 multiplied by 1.01). The semi-annual interest payment would then increase to $20.20 (2% multiplied by $1,010).

These semi-annual adjustments continue over the life of the bond. The end result is that when the bond matures, the principal returned to you is the inflation-adjusted equivalent of the amount you originally invested.

How Are They Taxed?
The interest payments and the increase in principal are both taxed in the year they occur. That’s why investors are advised to hold RRBs inside a registered account.

What Do RRB Yields Mean?
The quoted yield of an RRB is the real, or inflation-adjusted, yield. For example, the Government of Canada RRB maturing on Dec. 1, 2031, currently yields about 0.94%. This is the yield, after inflation, that you would get if you held the bond to maturity.

RRBs trade at significantly lower yields than regular bonds. That’s because a big chunk of the yield on regular bonds consists of expected inflation. If you subtract the RRB yield from the regular bond yield of similar maturity, you get something called the break-even inflation rate.

NEXT: So What’s the Problem?

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So What’s the Problem?
For starters, RRBs typically have long maturities, which make them volatile when interest rates rise or fall. The longest Government of Canada RRB matures in 2044, the shortest in 2021.

Such long-term horizons are fine for pension funds that have to plan decades into the future, but retail investors’ circumstances can change a lot in that time. If they have to sell before maturity, they could be hit with a hefty capital loss if interest rates have risen.

“These things are being marketed wrong. They are not safe. They have lots of capital risk in them,” said Hank Cunningham, fixed-income strategist at Odlum Brown and author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market.

Puny Yields
The risks are especially high right now, he said, because Government of Canada RRB yields are at historic lows. Yields range from less than 0.6% for the shortest maturity to about 1% on the long end. Over the past five years, real yields have been as high as 2.8%, and have averaged about 1.75%.

The ultra-low yields reflect government efforts to kick-start the economy, particularly in the United States, Cunningham said. Rising demand for RRBs from retail and institutional funds has also pushed prices up and yields—which move in the opposite direction—down.

He considers the current yields an anomaly that will eventually get straightened out—and when that happens, watch out.

To take one example, an increase of one percentage point in yield would send the price of the ten-year RRB tumbling about 9%. While in theory that shouldn’t matter to someone holding the bond to maturity, in practice such a drop would be unnerving to most investors.

“I’m really determined that people not dive in here at the wrong time,” he said. “Clearly with the kind of performance that these real return bonds have had, real return mutual funds and ETFs are trumpeting their historical performance, and I don’t want to see people get sucked in by that either.”

An Alternative
If you’re worried about inflation, Cunningham recommends setting up a ladder of bonds with maturities ranging from one to ten years. Every year when a bond matures, you reinvest the proceeds in a new ten-year bond.

The benefit of spreading out your maturities is that it eliminates the risk of having to reinvest all your money when rates are low. It also allows you to take advantage of rising rates, because you’ll be reinvesting cash at higher yields.

“At some point real return bonds will have a role to play, but it’s not now,” Cunningham said.

Another View
James Hymas, president of Hymas Investment Management, said the low yields on RRBs suggest that some investors are worried about hyperinflation. They would rather accept a tiny real yield than suffer a loss in purchasing power if inflation really heats up.

But he’s no fan of RRBs, either, partly because they’re less liquid than regular bonds—but mainly because “they’re trying to do too many things at once. They’re trying to give you a fixed income and inflation protection, but they don’t perform either function particularly well.”

If investors want inflation protection, fixed-income portfolios are the wrong place to achieve it, he said. They should instead look to other asset classes, such as resource stocks, to counter the impact of inflation on their bonds, he said.

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