Can I use real return bond ETFs as fixed income?

Q: Several years ago I owned real return bond mutual funds and they did quite well for me. Are there real return bond ETFs, and if so, would they be acceptable for the bond portion of my Couch Potato portfolio?

– Francesca, Richmond Hill, Ont.

A: One of the enemies of bond returns is inflation. Say you bought a bond today that will pay 3% annually for the next 20 years. Assuming inflation is running about 2%, you can expect a “real” (that is, inflation-adjusted) return of 1%. But what if inflation rises during the life of your bond? The real return on your bond would shrink, and could even become negative.

Real-return bonds (RRBs) are designed to overcome this shortcoming by delivering a return that is pegged to inflation. Both the interest payments and your original principal are adjusted twice a year based on the Consumer Price Index. When you buy an RRB with a yield of 0.5%, that means the bond will pay you a return of 0.5% plus the current rate of inflation. (Remember, though, if the rate of inflation decreases over time, RRBs will underperform traditional bonds.)

There’s a lot to like about real return bonds: not only do they offer an almost perfect hedge against inflation, they’re not highly correlated with stocks or even traditional bonds. That makes them a good diversifier in a balanced portfolio. If you’re looking to add this asset class to an ETF portfolio you have two options: the iShares Canadian Real Return Bond Index ETF (XRB) and the BMO Real Return Bond Index ETF (ZRR).

Unfortunately, there’s a problem with RRBs in Canada: there just aren’t that many. In fact, the federal government currently has just seven real return bonds available, and the provinces offer even fewer. Moreover, most RRBs in Canada have very long maturities, some as far off as the 2040s. Long-term bonds are highly sensitive to interest rates, so they can fluctuate dramatically. In 2009 through 2011, and again in 2014, XRB enjoyed double-digit returns. But in 2013, the fund lost over 13%.

Most investors understand that stock prices can be volatile, but they seem less willing to tolerate big swings in their bond portfolio. And that’s perfectly reasonable: the fixed income portion of your portfolio should be there to reduce volatility. Traditional bonds, especially those with shorter maturities, do a better job in that role.

If you understand the risks of RRBs and you are prepared to tolerate their roller-coaster returns, they can be a useful part of a Couch Potato portfolio, but they should only form part of your fixed income holdings. In a balanced portfolio with 40% bonds, for example, consider using a traditional bond ETF for 30% and a real-return bond ETF for the other 10%.

—Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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