≡ Menu

A Primer on Real Return Bonds

This is a column by regular contributor Clark.

Part I (The types of bonds) of the bond series had briefly touched upon real return bonds (RRBs), where I made an error in the calculation of my example. I posted a comment with the correction after Mike Holman of the MoneySmartsBlog pointed it out. This post will look at the bond class in detail.

Conventional bonds (both government and corporate bonds) provide fixed income and protection during stock market volatility. However, inflation is bound to eat into conventional bond returns as it would for any asset class. Conventional bonds may tout an annual yield of 5% but the real yield (after inflation takes its cut and when held to maturity) could be 2 or 3% (based on the existing rate of inflation). It could be argued that the real yield may be higher during deflation but it is a rare occurrence. Either way, there is significant uncertainty in terms of the purchasing power of that invested amount (principal + return) at the maturity of the bond. RRBs were introduced by the Government of Canada (US readers have the Treasury Inflation-Protected Securities, or TIPS in short, courtesy of the US government) to provide a hedge against inflation by earning interest on principal that is adjusted based on the Consumer Price Index (CPI).

The Indexing Process

The index ratio is used to compute the coupon or interest payment and inflation adjustment.

  • Index Ratio @ current date = (Reference CPI applicable @ current date) / (Reference CPI applicable @ the date of issue of the bond)

The reference CPI applicable on the first day of any month is the CPI for the third preceding month. For example, the reference CPI for June 1 of any year will be the CPI for March from that year, which will be released in April. For any other day of the month, the reference CPI is determined by linear interpolation between the reference CPI applicable to the first day of the month in which the day in question falls and the reference CPI applicable to the first day of the month immediately following. If the CPI is not released for any month, then the Government of Canada publishes a substitute index figure that will take precedence over any CPI figure that may be released at a later date for the month in question. Generally, interest on RRBs is paid on the first day of June and December of the year.

Payments

Interest for RRBs is paid semi-annually and the inflation adjustment upon maturity of the bond.

  • Interest (6-month period) = (Coupon or Interest Rate / 2) * (Principal * Inflation Adjustment at the time)
  • Inflation Adjustment = (Principal * Index Ratio) – Principal
  • At maturity or when sold, Final Payment = Principal + Inflation Adjustment at the time

An Example

A $10,000 RRB at 3% coupon rate with inflation at 2% would provide the following returns:

  • Interest (6-month period) = (0.03/2) * (10,000*1.02) = $153.0
  • If inflation rises to 3% after 1 year,
  • Interest (second 6-month period) = (0.03/2) * (10,000*1.03) = $154.5
  • Final Payment = 10,000 + Inflation Adjustment at maturity or when sold

Risk Factors

  1. Liquidity. After the issuance of a new series of RRBs, a secondary market should be available for trade, which may or may not be at par with conventional bonds.
  2. Price. Since the bonds are linked to the CPI, real yield is heavily dependent on the economic developments in the country.
  3. Principal Loss. There is a possibility (unlikely but not impossible) that if a period of sustained deflation occurs during the holding period, then the bond owner may be left with an amount that is less than his starting investment. In such a situation, the interest payments would also be negatively affected.
  4. Income Variation. If the bond investor is planning to use income from RRBs for his monthly expenses, then he would be better off with a sufficient emergency cushion to ride out the fluctuations in the CPI. A significant change in the CPI over a 6-month period may decrease his monthly income and throw his budget into disarray.

Taxation

RRBs are considered as ordinary income and hence, they are taxed at marginal rates when held in a non-registered account. Inflation adjustment is also taxed annually as it accrues, though the bondholder will not receive the money until maturity. So, the best place for RRBs, just like most other bonds, is registered accounts such as an RRSP or TFSA.

In the case of a Canadian non-resident bond holder, the coupon and inflation adjustment payments are exempt from the withholding tax.

Ways to buy RRBs

As is the case with other bonds, RRBs can be bought as individual issues, mutual funds (beware of expenses!) or ETFs (XRB or ZRR).

Do you own any RRBs? Do you think it has been (or will be) a worthwhile addition to your overall portfolio?

About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.

-> If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).

About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 8 comments… add one }
  • Chris Tringham October 15, 2010, 9:13 am

    Does Frugal Trader actually write any original material anymore?

    Or has MDJ now become a free forum for rookie journalists to share their thoughts.

    Disappointed.

  • Money Smarts Blog October 15, 2010, 10:37 am

    Great article.

    I own these bonds in my portfolio via iShares XRB. I think it’s about 5% of my portfolio, although to be honest, I can’t quite remember. :)

    I think they are a good diversifier in an investment portfolio, but as you mentioned – only in a registered account.

    @Chris – Maybe you should ask for your money back? ;)

    Mike

  • Clark October 15, 2010, 8:34 pm

    Thanks Mike. Getting behind on tracking your asset allocation, I see ;)

  • roosteroo October 15, 2010, 11:52 pm

    I would like an expert to answer the following question I have been wondering for two years now:

    A basic rule of finance states that bond prices go down when rates rise. This is because the amounts (interest + principal) are fixed and inflation eats away at it more quickly.

    With the RRB, there is an adjustment made to the interest payments to compensate for inflation.

    What would be the behaviour of a RRB given a large inflation environment (say 6 % /year)? Would the increased interest payments be more than enough to compensate for the inflation? Or simply a hedge?

  • FT FrugalTrader October 16, 2010, 8:33 am

    @Clark, I also thought it was a great article.

    @roosteroo, the way I’m understanding is that the principal of the bond is adjusted for inflation, then the set interest rate is paid on that adjusted principal. So, as Clark states in the article, if you bought $1,000 worth of RBB’s, with a 3% interest rate, and inflation was 6%, the bond value would be calculated as $1000 x 6% = $1060 with which the 3% interest is applied (semi annually).

  • Jungle October 16, 2010, 9:16 am

    I’m bounded out right now. It will be interesting to see what the US fed does next month and how that will affect bond prices with QE2.

  • Henry October 16, 2010, 3:42 pm

    PHN Inflation-Linked Bond Fund is good choice with a MER of .53% if you are holding it for less than 5 years.

  • Clark October 16, 2010, 4:27 pm

    @FrugalTrader: Thank you!

    @roosteroo: FrugalTrader answered it for you. RRBs are only a hedge against inflation and help to retain the purchasing power of your money in the future, irrespective of the inflation rate.

Leave a Comment