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Real return bonds provide inflation protection in your RRSP

by Wayne Cheveldayoff, 2004-05-13

With inflation possibly headed higher, it may be time to put some inflation-indexed bonds, known as real return bonds, in your RRSP.

Real return bonds (RRBs) compensate investors for inflation by linking the interest coupon and the principal to the consumer price index (CPI).

If the CPI goes up 2 per cent in one year, the amount of interest you receive will also go up by 2 per cent, and the principal is also adjusted higher by the same amount.

Due to an onerous tax treatment, it makes little sense to hold RRBs outside of a registered plan. The upward adjustment of principal each year to reflect inflation has to be reported as income even though the taxpayer doesn’t receive this benefit until the bonds are sold or mature.

But RRBs are appropriate for RRSPs, RRIFs and RESPs, although the decision to use them shouldn’t be automatic.

The reason is that RRBs should be considered in relation to what else is in the portfolio. Equities generally provide inflation protection over long periods of time. But if you are committed to having a large holding of bonds in your RRSP, it may be wise to have part of it in RRBs as a way of hedging your bets on inflation.

In Canada, the main issuer of RRBs is the Government of Canada. There are four different issues, with a total $16.6 billion outstanding, or about 5 per cent of total federal government debt.

All four issues started as 30-year bonds, with the first issued in 1991: It had a 4.25 per cent real coupon and a maturity date of December 1, 2021. The others are: Canada 4.25 per cent maturing December 1, 2026; Canada 4 per cent maturing December 1, 2031; and Canada 3 per cent maturing December 1, 2036.

While all the bonds were initially issued around $100, the decline in real yields in recent years has caused their price to increase. The Canada 4.25 per cent of 2021s were recently priced at $126.35, providing a real yield to maturity of 2.4%.

As with regular bonds, the yield to maturity for RRBs is a combination of the coupon received every six months, adjusted in this case for the capital loss (you are buying at a higher real price than the 100 your receive at maturity).

If you buy this bond now and hold it for the full 17 years to maturity, you can expect to receive a real return of 2.4 per cent, plus whatever happens to the CPI (up or down).

The fact that these bonds have an index ratio applied to both the principal and coupon makes them more complicated than regular bonds. The following example illustrates how this works.

If you had purchased $100,000 face value of the Canada 4.25 per cent of 2021 at the stated price of $126.35 for settlement May 12, 2004, your total cost would have been $160,004.70.

Here is the breakdown: the real price of $126.35 (per $100 face value) produced a real cost of $126,350. The index ratio for this bond for the May 12 settlement date was 1.24762. Applying this index ratio raised the after-inflation cost (or principal) to $157,636.78.

Added to this was the $2,367.92 in accrued interest from the last payment date (December 1, 2003), which will be returned as part of the coupon payment due June 1, 2004. The accrued interest amounts to the real coupon payment ($4,250 annually for a face amount of $100,000), adjusted for the number of days since December 1 (163 out of 365 days), and further adjusted by the index ratio (1.24762).

Every time you receive a coupon payment for this bond, it will be the stated real coupon (4.25 per cent of face value annually, or 2.125 per cent every six months), adjusted by the index ratio at that time. If you sell the bond, the real selling price will be adjusted by index ratio at the time of sale. If you wait until maturity, you will receive back the $100,000 face value times whatever the index ratio is at that time.

There is a different index ratio for each RRB. The ratios for a month ahead are published monthly by the Bank of Canada and can be obtained on the Bank’s website at www.bankofcanada.ca. For example, the index ratio for the Canada 3 per cent of 2036s for settlement May 12 was 1.00638.

If you decide that RRBs are right for your portfolio, there are different ways of adding them. You can invest directly in the Canada RRBs mentioned above. Quebec also issues real return bonds, and so does the U.S. Government, although those would have to fit within the maximum 30 per cent foreign content rule for RRSPs and RRIFs.

Direct investing in bonds makes the most sense, since it avoids losing a good chunk of annual return to the payment of the management expense ratio (MER) on mutual funds.

However, for investors who prefer them, there are two mutual funds in Canada that hold only real return bonds. They are the TD Real Return Bond Fund (MER of 1.65 per cent, one-year return to March 31 of 12.45 per cent) and Mackenzie Sentinel Real Return Bond Fund (MER 1.88 per cent, one-year return to March 31 of 10.28 per cent).

While the returns of the past year look attractive, investors should keep in mind that this is because real yields have fallen recently due to an appreciation in the real price, as a pickup in inflation expectations has inspired more demand for real return bonds.

There has also been a longer-term decline in real yields, which topped 5 per cent in the early 1990s, due mainly to the decline in nominal yields for regular bonds.

If general interest rates levels rise in the future (as they will if inflation picks up significantly), investors should also expect that real yields will also rise, although probably not as much. In other words, in an inflationary climate, real return bonds should outperform regular bonds with the same maturity, although the price of real return bonds could still drop.

Aside from short-term timing considerations, the decision on whether to buy real return bonds for your RRSP rests with your outlook for inflation. A regular Government of Canada bond maturing in 2021 has a yield to maturity of around 5 per cent. A Canada strip bond maturing at the same time has a yield of 5.5 per cent.

So, these regular bonds are already factoring in inflation of 2.6 to 3.1 per cent annually (the margin over the real yield of 2.4 per cent). If you think inflation over the next 17 years will be a lot higher than this, you would be better off in real return bonds. If you think inflation will be less, you’ll get a better total return from regular bonds.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff