Real return bonds (RRBs), which offer investors a hedge against inflation, are currently selling at a discount against conventional bonds of the same 30-year term because inflation has remained low and steady for so long. But when inflation does finally pick up, the tables will turn. So, does this present a buying opportunity?
With the consumer price index (CPI) in Canada rising by just 1.9 per cent for the 12 months ended Sept. 30, other asset classes like equities, which tend to rise when there is moderate inflation and more money chasing goods and services, would seem to be a better deal to obtain inflation protection.
The difference is that stocks carry other risks, such as being susceptible to dips in corporate earnings and investors’ moods. RRBs, issued primarily by the Government of Canada and the provinces of Manitoba and Quebec, are secure. Like other government bonds, they are immune from the wobbles of corporate performance. In addition, their principal and interest payments rise along with inflation.
In operation, RRBs’ principal, or face value, moves with the rate of inflation. So, for example, if inflation rises by one percentage point, the face value of the RRB will rise to $1,010 from $1,000. Then, the interest payment, which is a fixed percentage, will rise along with the higher face value.
RRBs returned 9 per cent for the 12 months ended Sept. 30, lagging the 9.69 per cent total return (bond price changes plus interest payments) of the FTSE TMX Canadian Bond Universe Index during the same period. Furthermore, RRBs, with their locked-in inflation protection, currently yield 1.27 per cent, which is 38 basis points lower than the nominal 1.65 per cent yield for the 30-year Government of Canada bond.
“Right now, RRBs are a good deal,” says Chris Kresic, head of fixed-income and asset allocation and portfolio manager at Jarislowsky Fraser Ltd. in Toronto. “If inflation is going to be higher than 1.27 per cent [annually] for 30 years, then RRBs are a better investment than long, conventional Government of Canada bonds. I expect inflation will be higher than 1.27 per cent for the next 30 years.”
Alexandra Gorewicz, vice-president and portfolio manager at Signature Global Asset Management, a unit of CI Investments Inc., takes a contrary view on the value of RRBs. She currently holds about $12-billion in bonds in the investment funds she manages, but has no exposure to RRBs whatsoever.
“Investors are not eager to buy inflation protection when there’s not much inflation in sight,” she says. “Moreover, RRBs are long issues with low nominal interest rates. That makes them very sensitive to interest rate changes.”
It’s all a matter of perspective. RRBs are cheap now because Canadian inflation is low. And while inflation is expected to remain low next year, some predict it could go a touch higher.
“Our outlook for inflation in 2020 is a slight pickup to 2.2 per cent,” says Matthieu Arseneau, deputy chief economist at National Bank of Canada in Montreal. “Our forecast is a bit higher than the [Bank of Canada’s target of] 2 per cent because of price pressure from imports based on a weak Canadian dollar. We also have accelerating wages. That should result the CPI rising in the coming months.”
The value of holding RRBs turns on inflation trends and the value of buying inflation insurance. But there are other considerations to take into account. In addition to their sensitivity to changes in interest rates, RRBs don’t trade as much as conventional government bonds and have wider buy/sell spreads.
If inflation rises even to mid-single digit rates, such as 5 per cent, at some point within RRBs’ term, investors who hold RRBs should be rewarded. Without a return to mid-single digit inflation rates, the performance of RRBs will probably continue to lag that of conventional long bonds, which don’t include the cost of inflation protection. Moreover, there are good alternatives for inflation protection in other fixed income products.
“I would not buy real return bonds or even any federal [government] bonds because you pay a premium for their liquidity [and default protection],” says James Hymas, president of Hymas Investment Management Inc. in Toronto.
“A corporate bond exchange-traded fund with about 100 investment-grade issues pays an average 3.25 per cent, which is 2.6 times what RRBs yield now,” he adds.