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In terms of whether to allocate assets toward Canadian RRBs or U.S. TIPS, the TIPS market offers much more liquidity.Kameleon007/iStockPhoto / Getty Images

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Even if inflation has already peaked, some money managers still see inflation-linked bonds as a major long-term investment opportunity.

Real return bonds (RRBs) in Canada and U.S. Treasury Inflation-Protected Securities (TIPS) have already been among the best performing fixed-income products this year amid one of the worst bond market sell-offs in a generation.

Yet, despite early signs suggesting that inflation levels in Canada might be close to their peak, experts say the value proposition for RRBs and TIPS will remain strong as long as inflation stays above historical averages.

“The big question is how long and persistent will inflation be at current levels,” says Konstantin Boehmer, senior vice president and portfolio manager at Mackenzie Investments in Toronto, who co-leads the firm’s fixed income business. “It’s not my expectation, nor is it of the market, that we will stay at this level for that much longer.”

Inflation will come down, he says, it is just a matter of how much and how quickly.

Canadian products such as the TD Real Return Bond Fund – I, CIBC Asset Management Inc.’s Renaissance Real Return Bond Fund – Class A and iShares Canadian Real Return Bond Index ETF XRB-T are all down by between 12 and 16 per cent this year. In the U.S., popular TIPS products such as Vanguard Inflation-Protected Securities Fund Investor Shares and PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund LTPZ-A have declined by 10 and 24 per cent, respectively, over the same period.

While those declines can be at least partially attributed to rising interest rates, Alexandra Gorewicz, senior investment portfolio manager at TD Asset Management (TDAM) in Toronto, says investors who believe inflation will be “stickier” over the long term now have an opportunity to add some inflation-linked exposure in a bond portfolio following this most recent correction.

“The road from over 8 per cent inflation to, let’s say, 4 or 5 per cent will be a relatively quick one. I think we can easily get there in the next several quarters or within about 12 months” says Ms. Gorewicz.

“But then, the question is how long will the road be from 4 or 5 per cent back to 2 per cent?”

According to Vinayak Seshasayee, executive vice president and portfolio manager at PIMCO in New York, that road could end up being fairly long.

“We might be in for a period in which inflation is structurally higher than it was over the previous five to 10 years,” he says. “If that ends up being the case, then RRBs are actually an excellent investment even today.”

Real yields on longer-dated RRBs are currently between 1.2 and 1.3 per cent. That means an investor who buys one and holds it to maturity will earn inflation over that period plus an extra return of roughly 125 basis points.

“If you’re really concerned about inflation being structurally higher over the next decade or so, that’s quite an attractive valuation,” Mr. Seshasayee says.

Canada’s consumer price index (CPI) rose 8.1 per cent in June from a year earlier, according to Statistics Canada, although investors have good reason to believe that number will soon decline.

For example, stripping out June’s big spike in gasoline prices brings the annualized increase in CPI down to roughly 6.5 per cent. And the current price of gasoline in the country is already much lower than it was last month.

Why inflation pressures will persist

However, Mr. Boehmer says Canada remains above a threshold of inflation that is measured not only in terms of the rate of CPI increases, but also by the length of time the economy has been dealing with high inflation levels.

Another important factor, he says, is how uniform the price increases are across the various items within the CPI basket.

“The more they’re correlated, the more freaked out central banks should be,” Mr. Boehmer says. “It’s not just energy and food prices that are higher, it feels as if it’s creeping in everywhere [and] that’s something that central banks cannot tolerate.”

He adds Canada is in the process of leaving an “ultra-high” inflationary environment, but will likely settle at slightly higher inflation levels over the medium-term.

Depending on whether the economy enters a recession, TDAM’s Ms. Gorewicz says it’s now very likely that central banks will have “their resolve on fighting inflation tested.”

For that reason, she’s taking a more “tactical” approach to inflation-linked bond allocations over shorter time horizons. That could change depending on how the economy performs in the coming months, she says, but right now “we’re trading them more actively rather than seeing them as a strategic long-term allocation.”

PIMCO’s Mr. Seshasayee is pointing to the opposite, saying inflation-linked bonds make more sense “because you want inflation-hedging to be a part of your portfolio rather than some sort of market timing play.”

In terms of whether to allocate toward Canadian RRBs or U.S. TIPS, the TIPS market offers much more liquidity. Mr. Boehmer says it also offers “a much purer expression” of inflationary views as the Canadian response to major macroeconomic developments can often lag the U.S.

He likes them from both a strategic and tactical perspective, noting inflation-linked bonds offer something other asset classes may not provide.

“Everything else is just a financial instrument,” Mr. Boehmer says. “But inflation-linked bonds are a financial instrument that also has that direct connection to the real economy.”

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