Blogs & Comment

Time to buy inflation-protected bonds?

With government printing presses working overtime, many investors are searching for inflation-proof investments. One such vehicle is inflation-protected bonds known as Treasury Inflation Protected Securities (TIPS) in the U.S. and Real Return Bonds (RRBs) in Canada. (If you would like to know more how the latter work, see Appendix 1 for an explanation by Kory Brewster of the Fixed Income department of CIBC World Gundy).
Is now a good time to buy TIPS or RRBs? As Mr. Brewster says such vehicles can help ones portfolio keep pace with the cost of living, however.as with any investment, it is important not to overpay for [them] as doing so can offset the benefits of the inflation protection. And as we shall see below, RRBs don’t appear to be such great bargains right now.
The best measure by which to judge the value of an RRB [or TIPS] isthe break-even inflation rate (BER), adds Mr. Brewster. The BER is the difference between the yield on a nominal Government of Canada bond and the real yield (the yield less inflation) on an equivalent RRB.
Lets illustrate with an example. According to Bank of Canada data, the real yield on long-term RRBs is 1.53% as of Jan. 5. The nominal yield on long-term Government of Canada benchmark bonds is 4.08% as of Jan. 5. The difference (4.08%-1.53%) is 2.55% and represents the current BER.
Now, if the actual annual inflation rate until the bonds mature is less than 2.55%, then the nominal bonds will be the better investment. Their real return will be higher than the 1.53% currently paid on the RRB. Conversely, if the annual inflation rate ends up higher than 2.55%, the RRB would be better since its real return would be higher.
So, if you believe long-run inflation will exceed 2.55% per year, you will want to buy RRBs at this time. If not, the nominal bonds would be better to buy.
Will annual inflation be under or over 2.55% over the long run? I personally believe that the Bank of Canada will continue to adhere to its target of 1% to 3% annual inflation. This would make RRBs slightly overvalued relative to the mid-point of the central banks target range. So I would not necessarily be a long-term buyer at these prices.
The time to buy RRBs, in my opinion, is when the BER dips toward the lower boundary of the Bank of Canadas target range. In Chart 1 below showing theBER for the 2021 maturity (provided via Mr. Brewster), you can see that the time to buy RRBs was in late 2008 or early 2009. Back then, fears of deflation were rampant, which dragged the BER down to 1%.
The price of the iShares Canadian DEX Real Return Bond Index ETF(XRB) has accordingly followed the BER higher since the trough a year ago. As you can see in Chart 2below (Google graph), it has risen from $18 to $20.5, an increase of about 14% (in general, the price of XRB appears to track the BER).
Inflationary fears could still continue to mount as 2010 progresses and thus cause more appreciation in XRB, so I would continue holding the ETF or RRBs if you already own them (disclosure: I own XRB). However, at some point, the central banks will begin to withdraw stimulus from the economy and cap inflationary expectations (and, in turn,price gains in XRB).
Chart 1: Breakeven rate of inflation of 2021 maturity (1991 to 2009)

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Chart 2: Price Trend in iShares Real Return Bond ETF (XRB)

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Appendix 1: How Do Real Return Bonds (RRBs) Work?
RRBs are identical to traditional bonds in most ways, except that their cash flows keep pace with the cost of living. Inflation, as measured by the Consumer Price Index (CPI), is represented by the RRBs Index Ratio, which tracks changes in inflation since the bonds issuance. To keep pace with inflation, the Real Face Value of the RRB is multiplied by the continuously updated Index Ratio to determine the Nominal (current) Face Value. The semi-annual coupon payments are based on the Nominal Face Value. For example, suppose an investor holds $10,000 Real Face Value of an RRB. If the current Index Ratio is 1.35506, the Nominal Face Value today would be $10,000 x 1.35506 = $13,550.60. If the RRB has a semi-annual coupon rate of 4.25% the coupon payment would be as follows: Nominal Face Value x (Coupon/2) = Interest Paid Out $13,550.60 x (4.25%/2) = $287.95 Note that the coupon rate does not change, but as the Real Face Value is multiplied by the Index Ratio, the coupon payment fluctuates with inflation. At maturity the Nominal Face Value is returned to the bondholder. So both the coupon payments and the principal repayment fluctuate with inflation. While the calculations may appear complicated, what matters most is that inflation protection is achieved.