Inflation is due to rise along with a recovery in interest rates — and protecting fixed-income investors from those two forces is a delicate job for financial advisors.

That’s because real-return bonds, which are all long-term issues in the 27- to 30-year range, are designed to track changes in the headline consumer price index. But they are also long bonds — and, inevitably, subject to competition from other long bonds.

These days, bonds that pay a decent yield are at risk of posting losses. Long conventional Government of Canada bonds that pay 3.8% are likely to fall by about 8% in price for each percentage point rise in interest rates — and that’s just their intrinsic sensitivity to interest rate changes. As maturity approaches, the price drop disappears.

On the other hand, inflation-linked RRBs could add value if the CPI accelerates to 3% or more from its current rate of 2.4%. Making the right call on inflation is essential to pricing RRBs.

There are other ways to cover inflation risk. Common stock dividends tend to rise with corporate cash flows that are driven, in part, by inflation. Inflation is defined by commodities price trends, so taking a position in orange juice futures or pork belly contracts can provide a CPI hedge. The trouble is that fruit and bacon are driven less by monetary policy than by weather and the price of pig feed.

A purist who wants to insulate against changes in the value of money has to work within the money market. That means RRBs in Canada and Treasury inflation-protected securities — TIPS, for short — in the U.S.

But are RRBs and TIPS good deals? That all depends on the outlook for inflation.

RRBs are fairly valued in terms of the inflation outlook, says Derek Johnson, director of fixed-income with Toronto-based Aurion Capital Management Inc. : “RRBs are priced to an expectation of inflation of 2.38% a year on top of a real yield of 1.44%.”

Add up those two components of yield and you get 3.82%, which is what a conventional 30-year Canada bond pays now.

So, if RRBs are fairly valued, why buy them? After all, they create annual tax problems for inves-tors when held in non-registered accounts because the bond’s coupon payments vary with increases in the bond’s capital base. The CPI gain each year translates as a boost to the base — and that gain, as well as the interest paid, is taxable. On conventional bonds, only interest is taxable until bonds are traded or mature.





@page_break@RRBs and conventional bonds are a saw-off right now, but if inflation were to accelerate to 3% or more, then the RRBs’ returns would beat the returns of conventional bonds of similar term, says Chris Kresic, co-head of fixed-income with Montreal-based Jarislowsky Fraser Ltd. in Toronto.

Yet inflation is likely to remain tame in Canada for many years, Kresic says: “The Bank of Canada’s target for inflation is 2%, and it has been adept at meeting that target. In fact, the overall CPI rate of growth since the early 1990s has been 2%. Moreover, we are one recession away from having another negative number on inflation.”

Overall, Kresic suggests, the conventional bond will be a better deal.

In the U.S. bond market, TIPS offer more inflation-driven return potential, says Jack Ablin, chief investment officer with BMO Harris Private Bank in Chicago: “Currently, TIPS pay 2.16%, on top of which there is a 2.51% inflation adjustment. So, the total TIPS yield is 4.67%, which is precisely what a 30-year T-bond pays. The inflation rate in the U.S. will be more than 2.5% in the next few decades. Our politicians will want higher inflation rates. That makes it easier to repay debt and allows the U.S. to export products in a weaker currency.”

The inflation-driven boost for U.S. TIPS could beat the equivalent boost on RRBs, but the U.S. dollar has a 4% downside compared with the Canadian dollar. So, should you pick TIPS over RRBs?

No, says Camilla Sutton, chief currency strategist with Scotia Capital Inc. in Toronto, because foreign-exchange losses could offset the relative advantage of TIPS: “Over the next 10 years, the loonie will weaken against the US$.”

(Scotia Capital’s latest prediction is that the US$ will lose 4% of its value vs the C$ next year.)

But while RRBs may not have a clear advantage over conventional bonds, that doesn’t mean that they are of no value in a portfolio. As Tom Czitron, managing director and chief investment officer with Morrison Williams Investment Management LP in Toronto, notes, there is a continuous lineup for long bonds in Canada. That’s because insurance companies are mandated by regulators to buy long government issues. So, the demand for RRBs is strong and can hold up RRB prices. Thus, what clients may not get on yield, they could get in capital gains.

In the end, RRBs are not so much about getting the highest bond return as about inflation insurance. As Benoît Poliquin, vice president of Pallas Athena Investment Counsel Inc. in Ottawa, says: “You buy RRBs and hope they never make a lot of money for you.” IE