The real problem with inflation-protected bonds

First, a quick refresher. RRBs are a type of government bond designed to protect investors from the effects of inflation. Both their face value and interest payments are pegged to the Consumer Price Index and adjusted twice a year, which means you’re guaranteed to maintain your purchasing power over the life of the bond. That feature overcomes one of the biggest shortcomings of traditional bonds.

What advisors need to learn about ETF investing »

There’s little question that RRBs are useful in theory. Consider a retiree who needs $50,000 annually to meet her expenses today. She could build a 10-year ladder of traditional bonds with a face value of $50,000 each, but by the time that last bond matures $50,000 won’t buy as much as it used to. Assuming 2% annual inflation, its purchasing power will erode to less than $41,000 in 10 years. If she builds a ladder of RRBs instead, the inflation adjustment would ensure the proceeds of each maturing bond will buy a similar amount of groceries, clothing and furniture every year.

Even if you’re a long way from retirement, real-return bonds are a useful diversifier. They have a generally negative correlation with equities—which means they tend to go up when stocks go down—and do not move in lockstep with traditional bonds. That means including a slice of real-return bonds can lower the overall volatility of your portfolio.

An issue of maturity

So with all of these positive characteristics, why did I remove RRBs from my model portfolios? Because the theory isn’t easy to put into practice in Canada.

In the US, real-return bonds are called Treasury Inflation-Protected Securities, or TIPS. They are issued regularly with five-, 10- and 30-year terms, and there is an active secondary market, which means you can buy them at all maturities relatively easily. Or if they prefer, US investors can use the iShares TIPS Bond ETF (TIP) or Vanguard Inflation-Protected Securities Fund (VIPSX) to buy a basket of about 40 issues with an average maturity of 8.7 years, roughly the same as a traditional broad-market bond index fund. Americans can even buy inflation-protected I Bonds directly from the US Treasury, similar to our Canada Savings Bond program.

What sky-high bond prices mean for your yields »

In Canada, the market for real-return bonds is far more limited. The feds started issuing real-return bonds in 1991, the same year the Bank of Canada set an inflation target of 1% to 3%. But they are generally issued with 30-year maturities, and in much smaller volume. The provinces of Ontario, Manitoba and Quebec have also issued some RRBs, but the overall pickings are slim in this country.

As a result of the limited choice, virtually all Canadian real-return bond funds are highly concentrated in just seven issues, and the average maturity is more than double that of their US counterparts, at just under 20 years.

Here’s a glimpse of the main holdings of the only two ETFs in this asset class—the iShares Canadian Real Return Bond Index ETF (XRB) and the BMO Real Return Bond (ZRR)—along with the actively managed TD Real Return Bond Fund and the PH&N Inflation-Linked Bond Fund:

Sources: BlackRock, BMO, TD Asset Management, Phillips Hager & North. ETF holdings as of May 26; mutual fund holdings as of April 30.

A roller coaster ride

The long maturities and low coupons of RRBs in Canada give them a very long duration—just under 16 years for the BMO and iShares ETFs. This means they are extremely sensitive to changes in interest rates: even a modest move can cause the value of these funds to rise or fall by double digits. Have a look at the returns of XRB for the six calendar years before I removed them from my portfolios:

Source: BlackRock

That’s a nice annualized return of 6.84%, but at the cost of huge volatility—and so we arrive at the main reason I removed real-return bonds from my model portfolios. It’s really about behaviour. In my experience, investors generally accept that equities are volatile, and they are willing to endure big swings because they know they can expect meaningful returns over the long term. But most find it difficult to tolerate that level volatility in their fixed income, which is after all supposed to be the stable part of a portfolio. With real yields close to zero these days, the combination of low expected returns and massive volatility is not compelling.

The trouble with bashing bond indexes »

Even if RRBs can lower the overall volatility in a portfolio, it’s easy for many investors to lose sight of the big picture and to focus on this one asset class in isolation. When they do that, they tend to make poor decisions, like selling low or refusing to rebalance.

If you understand the risks of real-return bonds and are willing to accept their high volatility, they might still be a worthy addition to a diversified portfolio, though I would recommend they make up no more than a quarter of your fixed income holdings. Most Canadians, however, are likely to find a smoother ride with more traditional holdings. That’s why I recommend a plain old broad-based bond index fund for most investors, particularly those who are still growing their portfolios. If you’re in or approaching retirement—or if you simply prefer low volatility—then use a short-term bond fund and perhaps a ladder of GIC.

This article was originally published at canadiancouchpotato.com.