For the second year in a row, real-return bonds are set to become the country’s best performing fixed-income investment. But, some analysts say, the good times may be behind us.

In the first 10 months of this year, the average total return on RRBs was 10.8%, or more than 600 basis points above the average of 4.7% earned by all bonds, according to Scotia Capital Inc. of Toronto. In 2004, RRBs posted a total return of 17.5%, which compares very favourably with a total return of 7.2% for all bonds.

These securities, which offer investors guaranteed inflation protection, are primarily issued by the federal government. In both years, the total return was helped by strong investor interest, which pushed prices up. Indeed, prices rose so much that the underlying “real” coupon fell to 1.6% from 3%.

“There was a dramatic decline in real yields last year. That was the main driver [of the return enjoyed by RRBs],” says Roger Quick, an associate director of fixed-income research at Scotia Capital. He says that because RRBs are long-duration bonds, a small change in yield leads to a large change in price.

“Real return bonds represent one of the few ways that, in a fixed- income sense, you can protect yourself against inflation,” says John Carswell, president of Canso Investment Counsel Ltd. , a Toronto-based fixed-income manager.

However, the torrid pace of returns may not continue, says Quick. Inflation expectations remain low and real yields have been driven down to low levels. “I wouldn’t be too negative on them, but I don’t think you will see the same kind of dramatic outperformance [we have had in the past],” he says. “I think performance will be a little more neutral.”

“We have some but we have reduced their weight because the coupon has lowered,” Carswell adds.

But, says Quick, if investors are concerned that inflation will really get out of hand and run ahead of most expectations, “these bonds will compensate for that.”

RRBs have been issued by Ottawa, Ontario and Quebec and several foreign governments. As well, there are two corporate issuers — 407 ETR International Inc. of Toronto, which owns and operates a toll highway north of Toronto, and Straits Crossing Finance Inc., the financing vehicle for the Confederation Bridge, linking Prince Edward Island and New Brunswick. The U.S., Britain and New Zealand are among the foreign governments that have issued the securities.

RRB investors receive a variable payment every six months based on a real interest rate and the change in the consumer price index over the period. At maturity, investors receive the full inflation-adjusted return of principal.

Accounting for inflation

Consider a $1,000 RRB bond with a 3% coupon. Let’s assume inflation is 2%. At the end of six months, the outstanding principal is adjusted to $1,020 to account for 2% inflation; the interest cheque is $15.30, calculated on the inflated-adjusted principle. Without inflation protection, the six-month dividend would be $15, based on an unadjusted principal value of $1,000. The process repeats itself every six months.

“If inflation is rising, real return bonds will outperform nominal [or regular] bonds. That’s the whole attraction to them,” says Quick.

“It comes down to what you think inflation will be over the life of the security vs how the market is pricing those inflation expectations,” he says, noting that inflation expectations of about 3% could justify buying an RRB.

Before investing, Carswell says investors should compare the implied real return on regular bonds and the real rate on RRBs. Recently, 30-year regular bonds were trading around 4.4%; real yields (i.e. after inflation) were at 1.6%. So investors would be better off with RRBs if they believe inflation will be more than 2.8%. If they believe that inflation will be less than that number, then they would probably be better off with regular bonds.

Investors should also be aware that they would suffer if there is deflation — or falling prices. In this situation, they could end up with a smaller interest cheque each month — or no cheque. And if deflation continues for a prolonged period, investors may receive at maturity an amount less than face value.

Carswell advises that if retail investors purchase RRBs, they should be held inside a tax advantaged account such as an RRSP. The reason is that the government taxes the inflation accrual — even though the investor doesn’t get the gain until the RRB is sold. “If the finance minister wanted to do something for the elderly investor then he should consider removing the taxation of the inflation accrual. It doesn’t happen in Britain and, as a result, there is a large retail interest.”

@page_break@Investors have a couple of ways to invest in RRBs. They can buy some from their investment advisors when a new issue appears or they can invest in RRB mutual funds. TD Asset Management Inc. and Altamira Financial Services Ltd. , both of Toronto, have such funds. TD’s Real Return Bond Fund has been around since November 1994 and has about $2.4 billion in assets. For the 10 years ended Oct. 31, 2005, it has posted an average annual compound return of 9.%; over the past year, the return was 11%. Altamira Inflation-Adjusted Bond Fund was formed last February, has assets of $7 million and, since inception, has posted a return of 6.14%. IE