Is inflation a monster that threatens to eat up fortunes in the years ahead? Judging by the recent performance of real-return bonds — debt instruments calibrated to track changes in the consumer price index — the answer is: no. And although that would seem to make RRBs as handy as sunscreen in a snowstorm, the characteristics of this unusual class of bonds could make them good buys.

For the record, the largest RRB mutual fund — TD Real Return Bond Fund, which holds $1.5 billion in the inflation-linked bonds — turned in a 2.7% loss for the 12 months ended Oct. 31. That loss follows the 3.5% loss for calendar 2006 and spectacular gains (for bonds) of 11% in 2005 and 14.2% in 2004. The recent loss suggests investors are not much worried about inflation — at least, for now.

RRBs’ prices have come back down to earth for several reasons. Declining inflationary expectations and their mirror image, increasing confidence in the ability of the Bank of Canada and other central banks to manage inflation, have reduced investors’ willingness to buy RRBs, which have a modest base interest rate and then add inflation compensation that precisely tracks the CPI with what amounts to a one-month lag.

As of mid-November, RRBs paid a base rate of about 2%, plus a 2.35% inflation-compensation premium, for a total of 4.35%. That is close to the yield to maturity of 4.42% on 30-year Canadas. You get a little less return on RRBs vs nominal bonds, but that makes sense. An RRB is asset protection packaged in a bond.

When inflation rates are high and investors expect more inflation ahead, bond buyers tend to be willing to pony up a premium to buy into RRBs.

From 1990 through 2005, Canada’s inflation rate has averaged 2.3% a year, according to data from Bank of Nova Scotia’s economics department. Going forward, inflationary expectations are declining. Scotiabank predicts inflation will be 2.2% for 2008. That’s a mild downer for RRBs. Federal Finance Minister Jim Flaherty’s Oct. 31 announcement to reduce the GST by one percentage point as of Jan. 1, 2008, will tend to reduce consumer prices, as well. In addition, the high Canadian dollar implies lower cost for imports, which tends to depress CPI increases. That is bearish for RRBs, which will have lower inflation-compensation premiums.

Fixed-coupon bonds pay their interest with no inflation adjustment. If inflation rises, driving up interest rates, these conventional bonds tend to drop in price. If inflation subsides and interest rates decline, these bonds tend to rise in price. Currently, the U.S. Federal Reserve Board is widely seen as being on an interest rate-cutting trend. The Bank of Canada, which has not yet signalled a cut in rates, will probably follow the Fed or risk high Canadian interest rates drawing in even more loose cash and bidding up the C$ even further. Interest rate cuts by the Bank of Canada will tend to boost conventional bond prices.

Present trends suggest you buy conventional long bonds with terms of 14 to 30 years rather than RRBs. But is the case against RRBs closed?

Not quite. The yield curve is quite flat. Two-year Canada bonds yield 4.2%, and going out to 30 years for a three-decade-long bet adds only 20 basis points to the yield. “There is not a lot of value in long bonds,” says Chris Kresic, senior vice president for fixed-income at Mackenzie Financial Corp. in Toronto.

As Kresic notes, pension plans and life insurance companies have switched from being heavy buyers of RRBs a few years ago to putting money into real assets such as commodities, whose rising prices are driving inflation. Buying gasoline futures to track inflation is not the same as buying inflation-adjusted government bonds. A life insurance company is not going to stake its financial future on copper and orange juice. After all, a small loss on RRBs is nothing compared with the bloodbaths that can happen in the commodity pits.

Professional bond investors trade off inflation protection on RRBs against balancing interest rate risk and protection provided by long conventional bonds. Scott Waugh, who manages large bond funds for Investors Group Inc. in Winnipeg, notes RRBs tend to have more exposure to changing economic circumstances than short bonds. That higher sensitivity, called “duration,” is like beta for stocks. The higher interest rate sensitivity of long bonds such as RRBs gives them a good chance of outperforming shorter bonds with interest rate sensitivity.

@page_break@“RRBs can outperform the SC universe bond total return index in an environment of lower interest rates,” Waugh says. “In an environment of falling inflation expectations, RRBs would probably show interest rate sensitivity. They could appreciate from falling yields the same as conventional bonds, even as CPI increases appear to be diminishing.

“RRBs are long bonds, after all,” he adds. “And they have higher sensitivity to interest rate changes than the relatively short terms and lower durations of the SC universe.”

In other words, RRBs will do well if prices rise, and perhaps not so badly if inflation declines.

In the end, RRBs are just another asset class. After a tough 2006 and poor returns for much of 2007, RRBs are priced in a buying range, says Craig Allardyce, vice president and associate portfolio manager at Mavrix Fund Management Inc. in Toronto. He adds that it is reasonable to give up some yield for the inflation protection RRBs provide.

For the long run, a buy-and-hold client willing to accept a 4% RRB return for the next three decades can get value at today’s RRB yields. If insurers and pension funds find investing in real commodities too risky, they may move money back to RRBs. That would drive up RRB prices and could produce the double-digit gains RRB funds racked up from 2000-05, except for a 1.1% loss in 2001. TD Real Return Bond Fund, the sole player with a 10-year record, piled up a 15.7% return in 2000, beating even the SC long-term bond total return index by 275 basis points — a fortune in the bond business.

Even if the short-term outlook for RRBs is not as bright as for fixed-coupon bonds, the long terms of RRBs allow for periodic bouts of inflation and central banks raising interest rates to battle rising prices. Those conditions are why RRBs were created.

“For the longer term, RRB prices don’t look like they will go a lot lower,” Allardyce says. “Now, they are a reasonable value.” IE