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Inflation concern triggers introduction of new real return bond funds

by Wayne Cheveldayoff, 2005-02-24

Two real return bond mutual funds were recently introduced to meet the apparent growing investor concern about inflation.

The Dynamic Real Return Bond Fund, established last October, and the Altamira Inflation-Adjusted Bond Fund, announced February 1, will invest primarily in Canadian federal and provincial government real return bonds and those issued by governments of other countries up to the current 30-per-cent foreign-content limit.

The newcomers join two other real return bond mutual funds with similar mandates – TD Real Return Bond Fund (established in November 1994) and Mackenzie Sentinel Real Return Bond Fund (established in April 2003).

Dynamic and Altamira no doubt were attracted into the field by the recent rapid growth in assets for the other two funds. The TD Real Return Bond Fund had assets of $1.62 billion at the end of January, a 62 per cent increase from $1.02 billion on March 31, 2004.

In the same period, the assets of the Mackenzie fund more than doubled to $165 million from $66 million.

In just over three months from its inception last October to the end of January, the Dynamic Real Return Bond Fund has accumulated $36 million in assets.

The growing interest can only be explained by the desire of investors to hedge their bets on inflation, especially in registered plans like RRSPs.

Good performance may also have had some influence. The TD fund was up 11.6 per cent in the year to January 31 and the Mackenzie fund was up 9.2 per cent in the same period, according to GlobeFund statistics. This beat the Scotia Capital Universe Bond Total Return Index, which was up 6.8 per cent, and the average for all (mostly regular) bond funds of 5.1 per cent.
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For the five years to January 31, the TD fund (the only real return fund with a long history) recorded an average annual return of 10.5 per cent, compared with 8.5 per cent for the index and a 6.6-per-cent for all bond funds.

For the past 10 years, the TD fund produced a 9.1-per-cent average annual return, the same as for the index, but ahead of the 7.6-per-cent recorded for all bond funds.

Bond funds have benefited from declining interest rates in recent years. Real yields have also fallen, thereby boosting the price of real return bonds.

Real yields were around 4.25 per cent when the Canada real return bonds due December 1, 2021 were issued with a real coupon of 4.25 per cent in 1991. By May 6, 2004, the real yield on this bond was at 2.4 per cent. On February 18, 2005, it was 1.87 per cent.

Currently, the longest-dated Government of Canada real return bond (carrying a real coupon of 3 per cent and maturing in 2036) yields 2.05 per cent in real terms.

If you buy this bond now and hold it for 30 years to maturity, you can expect to receive a real return of 2.05 per cent, plus whatever happens to the consumer price index (CPI). The interest coupon and principal of real return bonds are linked to the CPI, as the index goes either up or down month by month. (Although it has rarely gone down, it could in an extended period of deflation, should that occur.)

If you have large holdings of bonds, you may want to consider investing directly in real return bonds. While you would have to pay a commission, this could be offset in a reasonable period of time by the significant savings from not paying a bond fund’s management expense ratio (MER) – approximately 1.65 per cent annually for both the TD and Mackenzie funds.

However, investing in a bond fund gives professional management and broad diversification, including provincial and U.S. Government real return bonds. It also is cost-effective for smaller investments, including monthly automatic deduction plans.

Real return bonds, held directly or via mutual funds, make the most sense in registered plans, such as RRSPs, RRIFs and RESPs. If you hold such bonds outside of registered plans, the tax treatment is quite onerous, since the CPI-linked upward adjustment of principal each year has to be reported as income even though the taxpayer doesn’t receive this benefit until the bonds are sold or mature.

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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©2005 Wayne Cheveldayoff