Getting Real Returns With Bonds
By: John McCutcheon
Government of Canada Real Return Bonds (RRBs) were first issued in the early 1990s to offer bond investors a new inflation adjusted vehicle. They carry the same security and credit rating characteristics as other Canada issues and have been issued from time to time in different series, with the coupon rate and maturity date varying for each series. There are currently four different series outstanding, with the most recent being the three per cent of December 2036. The bonds of a series may not be called for redemption prior to maturity for that series and individual certificates are not available to beneficial owners.
Real Return Bonds are issued with a nominal principal amount of $1,000 and pay interest adjusted in relation to the Consumer Price Index (CPI) for Canada. Interest on the bonds consists of both a semiannual interest payment based on the coupon, together with accrued inflation compensation and an inflation compensation component calculated based on the principal and payable at maturity. The inflation compensation is calculated for each coupon period based on the performance of the CPI. At maturity, in addition to the normal interest payment, a final payment equal to the sum of inflation compensation accrued from the original issue date to maturity (whether positive or negative) and principal is made. These two components are treated as income for tax purposes.
RRBs are traded in the same fashion as other government bonds, priced to yield the ‘real rate of return.’ In theory, the difference between the quoted yield to maturity of an RRB (before the inflation adjustment) and a like maturity Government of Canada bond is the anticipated rate of inflation. Using the values at the time of writing, the 2031 RRB yields 1.94 per cent and the extrapolated GOC bond yields 4.35 per cent. Therefore, one might infer that the expected future rate of inflation is 4.35 per cent minus 1.94 per cent or 2.41 per cent. So far this year, inflation has been hovering around 1.5 per cent to two per cent, so this would imply that that bond investors are expecting an increase in the rate of inflation in the future. However, studies by a number of analysts indicate that RRBs are not a reliable forecaster of future inflation rates.
As a tool for a bond manager, RRBs are problematic. Because of the unique nature of both the periodic inflation compensation and the adjustment at maturity, it is not possible to use conventional measures such as yield to maturity, duration, or convexity. These calculations all require data inputs that are unknown. To get around this, as typically RRBs make up a relatively small portion of the total portfolio, they are usually held back from the usual broad portfolio measurements. There is also an issue of liquidity. Trading volumes are smaller than conventional Canada issues and the total outstandings are significantly smaller than the conventional bond issues.
Another challenge with RRBs is that they will underperform in a period of deflation. The semi-annual payments to the bondholders will be reduced and, ultimately, the repayment of principal at maturity might even be less than the original face value. Conversely, conventional fixed coupon bonds will outperform as the economic situation would also imply a steady decline in nominal interest rates and a concomitant increase in the value of the conventional bond holdings.
Rising Inflation Expectations
The inflation compensation characteristics of RRBs make them most suitable for use in a period of rising inflation. When rising inflation expectations are eroding the value of convention bonds, RRBs actually hold or even gain in value. Because of this property, RRBs are particularly well-suited to managers that need to invest in anticipation of future interest rate levels to offset future payment requirements. For example, this enables a Defined Benefit pension plan manager to achieve virtual indexation to the CPI. So, for at least that portion of the plan that is invested in RRBs, the need to estimate the future rate of inflation is eliminated.
Bear in mind, however, that RRBs do not protect against a wholesale upward shift in interest rates that is not immediately motivated by inflation expectations. The nominal yield to maturity remains a function of interest rate movements and the protection only comes through the inflation compensation. Real Return Bonds offer, and will continue to offer, an interesting fixed income portfolio management tool for use in interesting times.
John McCutcheon is managing director at Barrantagh Investment Management.
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