Under the Hood: BMO Real Return Bond

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: BMO Real Return Bond Index ETF (ZRR)

The index: The fund tracks the DEX RRB Non Agency Bond Index, which consists of inflation-linked bonds issued by the Government of Canada. It seems to have been created specifically for this ETF.

The cost: The ETF’s management fee is 0.25%. As with other BMO funds, the actual MER will be higher because it includes GST/HST and some other expenses.

The details: This brand-new ETF (it started trading on Wednesday, May 26) holds five real-return bonds issued by the federal government, each making up about 16% to 23% of the fund’s assets.

Real-return bonds — or Treasury Inflation-Protected Securities (TIPS), as they’re called in the US — are an important asset class, and some financial experts recommend them as a core holding.

Both the principal and the interest payments of real-return bonds are tied to the Consumer Price Index, so they go up with inflation. Here’s an illustration of how this might work, courtesy of Bylo Selhi:

On a $1,000 bond, if the coupon interest rate is 3% and inflation is 1% after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3% by year end, the principal is adjusted to $1,030. You then receive another interest payment of $15.45. Assuming similar inflation over 10 years, you will receive $351.64 in interest payments while the principal will have risen to $1,343.92.

Real-return bonds typically have long durations: the maturity dates of the five in this ETF range from 2021 to 2041. Since real-return bonds were introduced in 1992, the average annual return has been 8.2%, which falls between that of short-term (6.6%) and long-term bonds (9.5%) over the same period.

The alternatives: Real-return bonds are an under-served asset class: until ZRR was launched, the iShares Real Return Bond Index Fund (XRB) was the only ETF of its kind in Canada. There are only two no-load mutual funds devoted to them — TD’s Real Return Bond Fund and Phillips Hager & North’s Inflation-Linked Bond Fund — and both are actively managed.

ZRR has undercut its iShares competitor in price — XRB charges 0.35% — although we’ll have to wait for the first Management Report of Fund Performance to learn what its all-in cost will be. TD’s mutual fund charges an onerous 1.42%; PH&N’s has a super-low fee of 0.53%, but brokers may require a minimum investment of $5,000.

What’s most interesting is that all of these funds have very similar holdings. The reason is simple: there just aren’t many real-return bonds to choose from. The federal government has just five issues, all of which are held by BMO’s fund. These five also also make up 86% of XRB, 60% of TD’s fund, and 80% of Phillips Hager & North’s. The only other significant issuers of real-return bonds are Ontario, Quebec and Manitoba, and provincial governments aren’t included in the index ZRR tracks.

The bottom line: It’s too early to pass judgment on ZRR: it will take at least a year to see if it’s able to keep its expenses down and track its index closely. But if it performs well, it will be an attractive alternative to iShares’ XRB, which currently holds over $594 million in assets. Given the extremely limited inventory of real-return bonds, performance of funds in this asset class really comes down to who can keep their costs lowest.

If you’re considering this new ETF, first look through the prospectus.

Disclosure: I do not own ZRR in my own portfolio. I have a small position in TD’s Real Return Bond Fund (too small to make an ETF cost-effective).