Some bond ETFs are thriving in today’s inflationary world, but not the ones you’d expect

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Could there be a more obvious ETF for protecting a portfolio from inflation than one holding real return bonds?

Trick question. Exchange-traded funds holding real return bonds seem like the no-brainer choice in inflationary times, given that they hold bonds that adjust the principal amount of your investment in line with increases in the cost of living. But what an epic disappointment these ETFs have been in 2021.

The iShares Canadian Real Return Bond Index ETF (XRB) was down 4.6 per cent on a total return basis for the year through Sept. 30, while the BMO Real Return Bond Index ETF (ZRR) was down a tick less than 5 per cent. Inflation’s running at nearly a two-decade high and these ETFs are losing money?

The reason can be found in the makeup of the Canadian real return bond market, says Alfred Lee, portfolio manager and investment strategist at BMO Global Asset Management. Issued by the federal government, these bonds have maturities as long as 30 or 40 years, Mr. Lee said.

With inflation moving higher, long-term bond prices have been falling. Real return bonds have been caught in this trend, even while they protect your invested principal from inflation. A quick primer from Mr. Lee on how that inflation hedging works: “Let’s say the consumer price index goes up 2 per cent. You could say that if you had $100 in real return bonds, then the investment that you made gets grossed up to $102.”

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Canada’s real return bond market is problematically limited in scope, but not its U.S. counterpart. Treasury Inflation-Protected Securities, or TIPS, are available in a range of maturities, which means you could zero in on a short-term option to contain the risk of rising interest rates. Long-term bonds take the hardest price hit when rates rise, while short-term bonds do somewhat better.

The BMO, iShares and Mackenzie ETF families offer products with exposure to TIPS. The BMO Short-Term US TIPS Index ETF (Hedged Units) – the ticker is ZTIP.F – has a portfolio duration of 2.6 years, compared with 16 years for ZRR. Duration measures sensitivity to interest rate changes – lower duration means more resilience when rates rise, and less of a tailwind when rates fall.

Listed for trading in January, ZTIP.F is too new to have published returns. But the underlying index has delivered a total return of 5 per cent so far this year.

The iShares 0-5 Year TIPS Bond Index ETF (CAD-Hedged) – the ticker is XSTH – has been around for just a few months and currently has a duration of 2.5 years. In the early going, it has outperformed broad-based and real return bond ETFs, based on share price. The Mackenzie US TIPS Index ETF (CAD-Hedged) – the ticker on the NEO Exchange is QTIP – has a duration of about 7.6 years and a 12-month total return to Sept. 30 of 4.5 per cent.

Mr. Lee noted that there’s an unhedged version of ZTIP, but most investors using the fund want protection against currency fluctuations. “If you currency hedge, it’s almost like you’re getting the equivalent of Canadian short-term real return bonds,” he said.

One more thing to like about those ETFs holding TIPS is lower fees. The management expense ratio for this type of fund is in the area of 0.17 per cent, while Canadian real return bond ETFs cost as much as twice that.

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