Inflation Protection: Are Real Return Bonds or TIPS the Answer?
Patience and perseverance have a magical effect before which difficulties disappear and obstacles vanish.
~John Quincy Adams
Inflation has been in the headlines a lot lately. Many point to food price spikes as a key factor in the eruption of bloody protests in the Middle East and North Africa. Instability in these regions has only added to inflation concerns as it has caused the price of oil to surpass the psychologically important $100 per barrel mark.
I recently wrote about where Canadians should invest if inflation rises and I included Real Return Bonds (RRBs) as an option. These are inflation-protected bonds issued by the Canadian government. They are analogous to the Treasury Inflation Protected Securities (TIPS) issued by the U.S. Treasury.
If you follow the financial markets at all, you likely noticed that bond prices have taken quite a dip from the end of October, 2010 although they have recovered a bit lately. Many attributed the fall in prices and rise in yields to the improving economy as well as emerging inflation expectations as a result of fast-rising commodity prices. If inflation expectations are rising, you might expect the prices of Real Return Bonds, and the ETF that tracks them (XRB) to rise as well. But that hasn’t been the case.
If you look at a chart of the XRB compared to the XBB, an ETF that tracks a broader index of bonds, you’ll see that, although the prices occasionally diverge, the XRB has basically followed the rest of the bond market lower over the past few months. This is important to note, because if you had bought the XRB back in the fall of 2010 on the assumption that rising commodity prices would spawn inflation, you would have lost money so far.
How Do Real Return Bonds Work?
Before we delve into the reason why the XRB hasn’t risen with inflation expectations, let’s look at what real return bonds are and how they can protect against inflation. Real Return Bonds share many of the same characteristics as the nominal bonds you’re probably more familiar with. There is a price component and a yield component. As prices rise, yields fall and vice versa.
Real Return Bonds are unique in that interest is paid (usually semi-annually) according to the inflation-adjusted principal of the bond. So the price of the bond is multiplied by the CPI (Consumer Price Index) rate and interest is paid on that amount. When the bond matures, your principal is repaid in inflation-adjusted dollars. So if inflation has risen, the purchasing power of the money you invested in the Real Return Bond will not be adversely affected – unless you believe, as some do, that the reported CPI figures grossly underestimate the true inflation rate.
How You Buy Real Return Bonds Matters
You can generally buy individual Real Return Bonds from your broker as you would any other type of bond. Be aware, however, that individual investors buying bonds don’t always receive the same pricing as institutions buying in volume. It’s no different for purchasing RRBs.
You can also purchase an ETF like the XRB, or a mutual fund that contains Real Return Bonds. If you choose a mutual fund, make sure the management expenses don’t eat into most of your returns. Some of them charge over 2%, which can leave you with little to no return in today’s low interest rate environment.
It’s important to remember that, if you buy the individual bonds and hold them to maturity, you’re pretty much guaranteed your interest payments and the return of your inflation-adjusted principal at maturity. But if you buy an ETF or mutual fund, the price of the security will fluctuate with the bond market. Some of these movements smooth out over time if you hold the fund for a long enough period of time as the fund manager buys new bonds when the existing ones mature.
Strategies for Buying Real Return Bonds
Most people buy Real Return Bonds as an ultra-safe component of their portfolio. But watching your RRB fund fall in price even as inflation expectations rise can be a little disconcerting. The truth, however, is that when inflation fears rise, interest rates rise with them and bond prices fall. That usually means all bonds, including Real Return Bonds.
One way to guard against this type of price activity might be to buy a portfolio of individual Real Return Bonds with laddered maturities, just like you might do with nominal bonds or GICs. That way, you have some bonds maturing every year or every few years. In terms of using ETFs or mutual funds, the answers are a lot less clear. Your strategy will depend on your time horizon and risk tolerance.
You can choose to buy a fund with the idea that you’ll be holding it for so long that the price moves will settle out over time. Or you can choose to trade the ETF as you would a stock, selling when it’s had a big move up and buying on dips. You would presumably still have a reasonably long time horizon for this strategy as well. You could also employ a rebalancing regimen similar to the one you use for other parts of your portfolio.
Zvi Bodie, a professor of finance and economics at the University of Boston, has advocated putting most or all of your retirement savings in RRBs and/or inflation-protected annuities. While his approach is controversial, it’s definitely intriguing. He sees RRBs as the ultimate safe haven for your money. If you’re interested in learning more, his book is called Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals.
While Real Return Bonds do in fact provide some inflation protection for your money, it’s important to understand how they really work in order to make the best of what they have to offer for your unique situation. I haven’t invested in Real Return Bonds yet because I’m leery of buying individual bonds as a small investor, but I don’t like the price risk in the ETF or mutual funds. Like any other investment, they require patience to learn the details and perseverance to stick to your plan.
Do you have any experience with Real Return Bonds?