Real-return bonds (rrbs) have behaved like hot stocks for several years, producing not just terrific returns but getting priced so high that they lock in yields of a fraction of 1% if held to maturity.

Yet, investors and advisors who hold RRBs may turn out to have been downright prescient. Still, the question is: should financial advisors be recommending RRBs to their clients?

Current returns of RRBs are astonishing. For example, the RRB due Dec. 1, 2041, recently has been priced to yield 0.37% per year to maturity. Canada’s current inflation rate is 2% and the conventional Government of Canada bond yields are 2.33%; so, the break-even rate – the conventional bond’s yield less the RRB yield – is 1.96%.

RRBs thus are just about fairly priced vs conventional bonds and in terms of expected inflation. If inflation rises, RRBs may beat conventional bonds; if inflation drops, RRBs have no cushion at all and will begin to bleed red ink. In the case of deflation, RRB payouts would eat up their capital and thus produce negative absolute returns. Yet, paper-thin margins on RRBs seem to be no deterrent to investors.

The DEX real-return bond total return index had generated a 14.93% gain for RRBs for the 12 months ended June 30, 2012. The index had posted an 18.35% return for calendar 2011, 12.52% for 2010 and 5.49% for 2009.

What has driven RRB prices has been both conventional bond returns and investors’ concerns about potentially rising inflation rates. For the five years ended June 30, RRBs had generated a 12.96% average annual compound return, vs 12.11% for conventional bonds. And investors have bid up RRB prices even higher than those of conventional bonds.

The critical difference is that while a conventional bond, such as a 10-year Government of Canada issue that recently has yielded 1.84% to maturity, 16 basis points below the current 2% inflation rate, the RRB can make up the deficit. A conventional bond, if held to maturity, cannot.

Thus, RRB investors are willing to take the bet that price trends will be positive, at least. That saving grace has caused RRB yields to drop. They now are lower than they have been at any time since the government of Canada established the domestic RRB market in December 1991, notes Christian Pouliot, senior portfolio manager for fixed-income with Industrial Alliance Investment Management Inc. in Quebec City. Scarcity is holding up RRB prices, he adds: while rates are low, there is no rush to issue more RRBs. Governments reason that interest rates could rise dramatically in the decades before RRBs mature, causing what is now cheap financing to become very expensive.

Understanding why RRB yields are very low helps to understand where they may go in the future. RRBs, although structured to pay their base yield plus inflation, are still long bonds and, therefore, have high sensitivity to interest rate changes. RRBs, traded like long bonds, are expensive because long Canadas are expensive, Pouliot explains. And RRBs have risks. The 2031 issue has an implied duration of 23.5 years, so a 1% rise in interest rates would take 23.5% off its market value.

That is not the end of the story, Pouliot adds: RRBs would lose value, but they would then recover and begin to track inflation; they also would be sought out as inflation hedging tools and gain because of their scarcity.

The RRB market is small. There are six federal issues maturing between 2021 and 2041, for a total of just $50 billion out of $450 billion of outstanding Government of Canada debt. There also are four Government of Quebec issues, mostly due between 2021 to 2044; a bond that backs Ontario’s Highway 407; and a single corporate RRB in Ontario, currently with a 2.9% yield to maturity.

For the immediate future, Pouliot suggests, RRBs should post good gains. The continuing global slowdown and the European sovereign-debt crisis imply higher prices on conventional bonds. RRBs, as long bonds, should gain in this scenario. If inflation does rise and if central banks can tame the debt crisis, he says, then RRBs also will do well.

The inflation outlook is not the only factor supporting RRB prices. Anticipated moves by the U.S. Federal Reserve Board to monetize debt, for example, through the usual practice of buying bonds or other debt, such as mortgages held by banks, will be inflationary. That will boost low RRB returns, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

RRBs could continue their winning streak if inflation takes off or if fear of inflation is widespread, says James Hymas, president of Hymas Investment Management Inc. in Toronto and a specialist in fixed-income investments, particularly preferred shares. Hymas explains: RRBs, when considered as insurance – not just for expected inflation but as insurance for unexpected inflation risk – make sense. This is a form of hedging against the unknown and is rational, Hymas notes, adding that because RRBs are not well correlated with any other asset class, they diversify portfolio risk. In the event of a return to high inflation, which could occur if governments overdo monetary stimulus, RRBs would pay handsomely.

There are, of course, other ways to hedge against inflation. Commodity-related and resources stocks usually track inflation, but agricultural commodities have weather issues unrelated to macroeconomic trends. Energy prices reflect extraction technologies – as investors in natural gas have realized. So, as a pure inflation hedge, RRBs remain unique. They pay little, but that has to be compared with recently negative returns on Canadian stocks. (The S&P/TSX total return index was down by 10.25% for the 12 months ended June 30. Compared with that, a guaranteed inflation tracker makes sense.)

RRBs are poised to gain as long bonds if interest rates drop and to rise in value if inflation rates rise. Based on those assumptions, RRBs are win/win investments. IE

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