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For investors who are worried about inflation but still want to own bonds, ETFs that hold real-return bonds tied to inflation may offer some protection.

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An argument can be made that, after a year of pandemic lockdowns and forced contraction, western economies are set for strong growth – with inflation and rising interest rates sure to follow.

That’s typically bad news for bonds, which have enjoyed decades of rising prices (and falling yields) as interest rates have tumbled from their 1980s peak, while inflation has been tame. Expectations of rising inflation generally leads to falling bond prices.

So is it time for ETF investors to give up on bonds?

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Not necessarily, says Brooke Thackray, a research analyst with Horizons ETFs Management (Canada) Inc, who keeps a close eye on the relationship between the bond and equity markets.

He notes there is an “inflation narrative” with higher consumer prices and cyclical sectors such as energy and commodities rising. However, that inflationary growth picture is not shared by the bond market, as the yield on the benchmark U.S. 10-year Treasury Note peaked on March 31, 2021, at 1.74 per cent, its highest level since early 2020. The yield now stands at 1.56%, as of June 4, 2021.

“So the bond market hasn’t been buying the narrative, basically,” he says. “Bond investors are looking forward so inflation expectations are high for the short term but if you go out five years, inflation expectations are actually quite benign.”

When there is a divergence in outlook between equity and bond investors, Mr. Thackray falls in with the far larger bond market which he says “tends not to get bashed around as much by speculation and emotion. You tend to find larger institutional buyers in the bond market and when you find convergence the bond market is usually correct.”

Mr. Thackray, who manages the Horizons Seasonal Rotation ETF (HAC-T), says longer-term signs say growth may slow and interest rates could even fall a bit lower.

“Overall, I think it is not a bad time for bonds right now, even buying medium-term government bonds or long-term government bonds,” he says.

He recommends investors consider the iShares government bond ETF (XGB-T), which provides exposure to Canadian government-grade bonds with a maturity of at least a year. XGB comes with a management expense ratio (MER) of 0.39 per cent. It has lost about 2.3 per cent over the past year and has a three-year annualized return of 3.6 per cent. (All data from Morningstar as of June 4).

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He also likes an ETF from his firm: the Horizons Canadian Select Universe Bond ETF (HBB-T), which uses swap contracts to produce bond returns and carries an MER of 0.10 per cent. HBB has performed relatively flat year-over-year and has a three-year annualized return of about 4 per cent.

The runaway inflation scenario, which would be kryptonite for future bond yields, tends to underestimate how lasting the impact of the pandemic has been on countries such as Canada and the U.S., says Daniel Straus, director of ETFs and financial products research with National Bank Financial Inc.

He says there has been “incredible demand destruction” due to the government lockdowns and restrictions.

“There are some catalysts for a more bearish long-term inflation outlook,” Mr. Straus says.

These include a trend for countries to “de-globalize” by bringing production home for critical goods such as medical equipment, pharmaceuticals and strategic components such as semiconductors. Add to that changes such as the end of the office and commuting for many, which could mean significant long-term impacts for many industries, from office real estate to retail to automotive-related businesses.

Mr. Straus describes bond holdings for most investors as “ballast” for a typically equities-heavy portfolio.

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For investors who are worried about inflation but still want to own bonds, ETFs that hold real-return bonds tied to inflation may offer some protection. Examples include the iShares Real Return Bond Index (XRB-T), with an MER of 0.39 per cent, or the BMO Real Return Bond index (ZRR-T), with an MER of 0.28 per cent. XRB has returned about 3 per cent over the past year and has three-year annualized return of 4.2 per cent, while ZRR has returned 3.4 per cent over the past year and has a three-year annualized return of 4 per cent.

Although they are designed to protect against inflation, the two ETFs “have a lot of rate risk” because many of the underlying bonds have long maturity terms, Mr. Straus says.

“They are very good for playing the inflation outlook. If you feel that inflation outlook is going to become bearish faster than the market has already anticipated, then you can use these kinds of ETFs as a trade.”

Investors can also look to the U.S. for shorter-term real-return bond ETFs such as the Mackenzie US TIPS Index Canadian-dollar hedged ETF (QTIP-NEO), with an MER of 0.18 per cent. It has returned about 6.8 per cent over the past year and has a three-year annualized return of 5.7 per cent.

Mr. Straus is less enthusiastic about longer-term bond ETFs given the uncertain inflationary environment.

“Runaway inflation is going to kill your bond holdings on both sides,” he says. “If the central banks do nothing, then your bonds will lose their purchasing power and if they do something, the only way to control interest rates … is hiking interest rates painfully,” as the U.S. did in the 1970s.

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For investors concerned about the future direction of interest rates, one option could be laddered bond ETFs such as the RBC 1-5 Year Laddered Bond ETF (RLB-T), with an MER of 0.25 per cent. It has returned about 2 per cent over the past year and has a three-year annualized return of 3.6 per cent.

“Laddered bond ETFs over term essentially lose duration and they reinvest it in the back end of the ladder,” says Yves Rebetez, an ETF analyst and partner of Credo Consulting Inc. of Oakville, Ont. If rates rise, investors benefit when money is reinvested from matured bonds.

Mr. Rebetez is less enthusiastic about corporate bonds, which could correlate too closely with returns of equity markets and potentially add credit risk from companies that can’t cover their debt obligations.

“You are not getting bonds that are giving you the full diversification of a sovereign bond,” he says.

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