Inflation – or the lack of it – has created a buying opportunity for financial advisors who want their clients to get in on a good asset at a cheap price. The deal: pick up inflation-linked bonds such as Government of Canada real-return bonds (RRBs) for cheap in a market in which the threat of inflation has subsided from a roar to a whisper, thus dragging down the prices of what the Street calls “linkers.”
The market for RRBs is minute: they are issued mostly by governments, and there are only a small number of issues with terms of 2021 to 2047, with the average term being 2035. There also are an Ontario Highway 407 bond and three provincial issues: by Manitoba, Ontario and Quebec. RRBs comprise a specialized market with less liquidity than that for other government issues.
For the 12 months ended August 31, the most traded RRB exchange-traded fund (ETF), BlackRock Inc.’s iShares Canadian Real Return Bond Index ETF, generated a humble 0.08% return in comparison to its iShares Canadian Universe Bond Index ETF, which has gained 4.51% in the same period. The difference is that, without food and energy, Canada’s consumer price index (CPI) is inching upward at a modest 0.2% (as of Aug. 31), down from 1.9% for all of 2014. Falling interest rates, aided by the Bank of Canada (BoC), have made most fixed-income investments winners while crippling RRBs, which set their returns by parallelling inflation.
Whether to give RRBs a thumbs up or down depends upon your view of how much inflation lies ahead and how RRBs will respond. The average term of the RRBs outstanding is 25 years, so they have the characteristics of all long bonds: high sensitivity to interest rates, and a scarcity effect driven by their popularity among pension funds and insurance companies that want to lock in future inflation-adjusted portfolio values.
Clearly, RRBs have lagged the broader Canadian bond market and, for that matter, most of the time-defined components. BlackRock’s iShares Core Canadian Long Term Bond Index ETF generated a 6.02% return for the 12 months ended Aug. 31, but there is a difference: with an inflation-linked bond, it is almost impossible to take a loss unless headline-rate CPI deflation breaks out long enough to force the redemption price of the bond to drop below par. That would work out to as much as 25 years of deflation, which is something Canada has not experienced.
The more likely scenario is that Canada’s inflation rate rises to the BoC’s long-term target of 2%, says Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto: “If inflation rises, you will be better off in bonds than in stocks.”
The question, of course, is which bonds. Conventional bonds have the advantage of offering a known coupon and they have, therefore, a known yield to maturity in nominal dollars. RRBs have a yield to maturity that can be estimated. That yield will be the break-even rate at the time of purchase, plus inflation to come. For now, Kresic notes, the break-even rate is 1.57%. That return is a market bet that the BoC will not achieve 2% inflation. But the central bank has a good track record in predicting and managing inflation.
The alternative is to buy a conventional long bond with full and uncompensated exposure to inflation. Yet, after a bad year for RRBs, the prices of which have been driven downward by declining inflation, a bet that inflation will rise is realistic, historically speaking.
“I would buy RRBs now [as] the break-even rate is the cost of inflation protection,” Kresic says. “That’s cheap.”
In numerical terms, the lowest break-even was 103 basis points (bps) in 2008; the highest, 300 bps in 2004. That means we are closer to the bottom than to the top of the historical range, making RRB inflation protection a good deal.
Behind that bet is the U.S. economic recovery. Rising levels of production and commodity prices, falling unemployment and the other indicia of growth will drift up to Canada and tend to raise demand for debt issues, thus boosting interest rates. Real yields would rise, which tends to boost the inflation premium accruing to RRB-holders.
That result appeals to bond portfolio managers. “I think that the Bank of Canada will succeed in getting inflation back to 2%,” says Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto. “That will happen because Canadian dollar weakness drives up clothing and food and other import prices. That is offset somewhat by lower energy costs, but the total effect is inflationary.”
The cost of holding RRBs is the difference between their current return of 1.57% and the 2.27% that a comparable 30-year Canada bond offers. Says Jong: “You are buying inflation protection at a specific price. But you have to do it in a cost-efficient way. There is very little interest for mutual funds to tap with [their] management expense ratios. You have an illiquid market, too.”
Given that RRBs are at risk if deflation appears and they provide only a modest return if inflation rises to 2%, they are more an insurance device than a way to make profits. “I would limit my clients’ bond portfolio exposure [to RRBs] to 10%,” Jong saysIE
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