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Real return bonds put in star performance while traditional bonds suffer

by Wayne Cheveldayoff, 2005-11-17

Real return bonds have done exactly what they are supposed to do in the past few months Ė protect investors from inflation.

As energy prices have pushed inflation rates up in recent months, real return bond funds have continued to move higher. At the same time, traditional bond funds have suffered.

One of the largest real return bond funds in Canada, TD Real Return Bond Fund, with assets of $2.3 billion, has gained 3.5 per cent in the three months ended October 31, 2005.

Similarly, the smaller Dynamic Real Return Bond Fund (assets $64 million) has risen 5 per cent over the same three months.

By contrast, traditional bond funds have lost between 1 and 2 per cent of their value in the same three-month period.

A representative example is Trimark Canadian Bond Fund, which lost 1.3 per cent between July 31 and October 31.

The differing performance is a predictable result of the upswing in the consumer price index (CPI).

The interest payments and principal of real return bonds are linked to the CPI. Investors get a real return plus whatever the CPI gains or loses. So, an upswing in the CPI benefits the holders of real return bonds.

Not so with traditional bonds. When inflation is on the upswing, traditional bonds rarely do well, as central banks are typically raising interest rates. When interest rates go up, traditional bond prices go down.

This differing performance raises the question of what investors should do. Should you switch out of traditional bond funds to avoid further losses in the future? Should some of that money go into real return bond funds?

The answer depends on how you view the future unfolding for inflation and interest rates.

In the 1970s, the last time North America suffered such large gains in energy prices, inflation rose to close to 10 per cent and the value of traditional bonds trended lower for several years.

However, this time most economists are expecting only modest gains in inflation and bond yields and central bankers in Canada and the United States are raising short-term interest rates with the intention of preventing a 1970s-type situation from developing.

The Government of Canada 10-year bond yield, an important barometer of the bond market, has moved up to 4.15 per cent recently from a low of 3.65 per cent during the summer.

TD Economics, for example, expects the yield to rise further to 4.6 per cent by the third quarter of 2006 before trailing off to 4.4 per cent by the end of the year.

In this type of mainstream scenario, holders of traditional bond funds may see the value of their units lose a little more ground and stagnate for a while. But it wonít be a 1970s disaster.

For real return bonds, much will depend on the CPI. If oil prices stabilize below their hurricane peak of US$70 per barrel, it is likely the CPI inflation rate will come down somewhat.

If so, real return bonds will likely continue to outperform traditional bonds but not by as much as they have in the recent three-month period.

Another consideration with real return bonds is that some of the gain in value has come from the decline in real yields. Long-term Government of Canada real return bonds had a 2.05 per cent real yield last February. As inflation worries picked up and investors moved into real return bonds, that real yield has declined to about 1.6 per cent recently, resulting in an extra boost to real return bond prices.

Itís part of the reason why real return bond funds are up more than 11 per cent in the past year, versus only 5 per cent for the average traditional bond fund. This positive influence of declining real yields is unlikely to continue, especially if inflation is brought under control and inflation worries dissipate.

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 doesnít receive the 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