Real-return bonds give you an easy way to buy inflation protection for your clients. They track changes in the consumer price index and, therefore, have a built-in inflation escalator; and when you combine that with their AAA ratings — as they are all government issues — the protection RRBs provide would appear to be bulletproof.

It also helps that for the year ended Dec. 28, 2009, RRBs produced a 15.1% return. That beat risky emerging-markets bonds, which produced a 14% return in the same period. (There is some bias in the numbers, however. Back in late 2008, investors were worried about deflation. So, with no inflation worries, investors sold off RRBs, and their prices slumped. But with the return of inflation concerns, prices of RRBs have risen and their gains have been spectacular.)

RRB pricing is nothing like that of conventional bonds, which gain or lose value inversely to interest rate changes. So, if interest rates go up, existing conventional bonds’ prices fall — and vice versa. RRBs, on the other hand, are priced at a low base rate, about 1.5% for the few issues on the market, and then add a bonus in the form of an adjustment for increases in the CPI.

The consensus is that the CPI should rise by about 2.5% annually for the next two to three decades. So, if you add 2.5% to the base 1.5% interest rate, you get 4%, which is what 30-year Government of Canada bonds are priced to pay. Remove the CPI compensation from the Canada bond’s 4% yield and you get a 1.5% real return.

This means that if inflation runs higher than 2.5% a year, the RRB investor will be a winner. If inflation runs below 2.5% or even turns negative and becomes deflation, the Canada bond’s owner will be the winner. Indeed, under prolonged deflation, the RRB would actually see its price drop as declines in the CPI cause the RRB bond’s value to fall.

Looking ahead, there is a good chance that inflation will rise, says Chris Kresic, senior vice president and head of the fixed-income team with Mackenzie Financial Corp. in Toronto: “Long-term inflation risks have increased, so inflation expectations will rise.”

Moreover, he adds, the average return generated by RRBs since they were first issued in the early 1990s has been 2.6%. The current break-even rate on RRBs — 2.5% — is below the average return on RRBs and the fundamentals — rising inflation expectations — are positive for RRBs. Kresic’s conclusion: add RRBs to bond portfolios.

“For the first time in 25 years, people are very worried about inflation,” says Tom Czitron, managing director and head of income and structured products with Sceptre Investment Counsel Ltd. in Toronto. “Given that RRBs are portfolio insurance for inflation, their returns will correlate with how governments cut deficits in the years ahead.”

In Czitron’s view, those governments will not be inclined to raise taxes sufficiently to repay their recent borrowing.

“It makes sense to have some RRBs,” says Michael McHugh, vice president and a portfolio manager with Dynamic Mutual Funds Ltd. in Toronto. “It is prudent, but at today’s low interest rate levels, you have to protect against interest rates rising.”

It would be simple to select RRBs over conventional bonds if inflation were the only issue. But RRBs are long bonds. Available market offerings vary in terms, with due dates ranging from 2021 to 2036. As such, they behave like long bonds, notes John Carswell, president of bond-management company Canso Investment Counsel Ltd. of Richmond Hill, Ont., as RRBs trade on supply and demand as well as inflation expectations.

“Looking down the road one to three years, we see more inflation,” Carswell says. “But in the year ahead, RRBs will be affected by an overall rise in real interest rates.”

He argues that if people fail to save — as he expects — then governments will do it for them. This process would see more bond sales, which would tend to push down all bond prices and, conversely, raise government-bond yields. The effect on existing bonds’ total returns would be negative, so Carswell is reducing terms on RRBs — a move both tactical and protective.

The most price-efficient way to buy RRBs for your clients is through mutual funds, such as TD Real Re-turn Bond Fund, which generated a 20.7% gain for the 12 months ended Nov. 30, 2009. The TD fund has a management expense ratio of 1.42% and a minimum purchase of $100.

@page_break@You could also buy RRBs through an exchange-traded fund, such as Barclays iShares RRB portfolio. In 2009, it produced a 17% return, net of its relatively low 0.35% MER.

With RRB funds or RRB ETFs, your clients get liquidity and price visibility. Managed funds, such as the TD fund, can beat the index with some shrewd manoeuvring, such as adjusting maturities and targeting specific periods of inflation.

There can be a tax problem, however. RRBs adjust their payouts by raising their capital base in line with the rise of the CPI. But rather than taxing growing capital as a capital gain, Canadian tax laws dictate that these gains be taxed as income. As a result, RRBs held in non-registered accounts create accounting headaches and lead to high tax bills. But held within registered accounts, they present no such problems.

RRBs tend to underperform conventional bonds. But when considered as portfolio insurance, RRBs either just cost the amount that they lag conventional long bonds or pay a premium if they beat them. IE