Ask the Spud: The role of real return bonds

Why has the iShares DEX Real Return Bond (XRB) dropped so dramatically this year? I thought this asset class was protective in times of rising interest rates (which are correlated with inflation), but perhaps I misunderstood. I also see the yield to maturity is almost zero. Please set me straight about the role of real return bonds in a portfolio. – K.T.

Let’s begin with a refresher on real return bonds, or RRBs. They have a lower coupon than traditional bonds, but their principal gets adjusted every six months according to the current rate of inflation, as measured by the Consumer Price Index.

For example, let’s say an RRB has a face value of $1,000 and a coupon of 3% annually (1.5% semi-annually). This bond would initially pay you $15 in interest every six months. However, if inflation rises by 1% before the next interest payment is due, the RRB’s principal will be adjusted upwards to $1,010. Now the 1.5% semi-annual coupon applies to this larger amount, and your next interest payment would be $15.15.

The coupons on federal RRBs today range from 1.5% to 4.25%, but the weighted average yield to maturity of XRB is 0.30%, which sounds dismal. But you need to understand that this is the real, inflation-adjusted yield. If you buy a 20-year RRB with a quoted yield of 0.30% and you hold it to maturity, you’ll earn a return of 0.30%  plus the inflation rate over that period. A nominal bond of the same maturity might boast a yield of 2.8%, but if inflation is 2.5% during the life of these two bonds, their total return will be the same.

In fact, if you want to learn the market’s expected inflation rate, you can look at the difference between the yield of an RRB and the yield of a conventional bond of the same maturity. As of February 27, the Bank of Canada lists the current yield on benchmark long-term bonds as 2.53%, while the yield on benchmark RRBs is 0.52%. That suggests the market’s best forecast for inflation is just over 2%.

Time to get real

The primary role of RRBs in a portfolio, then, is inflation protection. Investors often consider gold, commodities, real estate and dividend stocks as inflation hedges, and these asset classes may indeed offer some protection. But no asset class is more highly correlated with inflation than real return bonds. If you hold an RRB to maturity, your principal is guaranteed to maintain its purchasing power.

RRBs also play an important diversification role, since they are not highly correlated with equities, real estate, or even traditional bonds.

However, like all asset classes, real-return bonds are exposed to several risks, and investors need to understand these so they’re not surprised when the asset class performs poorly, as it has in the past year or so.

First, the average term to maturity of the DEX Real Return Bond Index is over 20 years, and the average duration is about 16. This makes RRBs vulnerable to rising interest rates. If long-term rates rise just half a percentage point, a fund such as XRB can be expected to decline about 8%. Long-term yields are currently about 20 basis points higher than they were last May, which explains a good part of this ETF’s recent price drop.

RRBs will also perform poorly (relative to nominal bonds) if inflation turns out to be lower than expected. And if the CPI declines during a six-month period, the principal of RRBs will be adjusted downward, which would causes XRB and similar funds to fall in value.

Remember, a diversified portfolio will always have short-term winners and losers: indeed, that is the whole point of diversifying. From 2009 through 2011, RRBs were double-digit performers: in the last of those years they returned over 17% while Canadian and international equities declined significantly. (I should note that investors were being told not to buy them at time.) Now the tables have turned: in the last 10 months or so, RRBs have declined while stocks have soared.

It would be wonderful if we could predict the  next outperforming asset and reposition our portfolios appropriately. Unfortunately, we cannot. So the sensible strategy is to diversify across many asset classes with low correlation, hold them all the time, and rebalance when appropriate.