The near-term prospects for a significant rise in inflation, which would push bond yields upward, are dim. But if inflation rises before real-return bonds (RRB) reach the middle of their term to maturity or beyond, they will be profitable; indeed, present prices for RRBs then will seem cheap. Investment in RRBs is a macroeconomic speculation with distant payoffs. The downside for clients is that money in RRBs may do better in conventional bonds absent rising inflation.
Recovery in the U.S. economy pushed up inflation to 2.5% for January, the latest month available, from 1.3% for all of 2016. Canada’s inflation rate, reported to be 1.5% for January, is about the same as for all of 2016 and shows no sign of rising by much.
The Bank of Canada (BoC) is on hold, awaiting developments in the way that the U.S. may try to adjust trading relations with its northern neighbour following the election of President Donald Trump. Increased restrictions on U.S./Canada cross-border trade would reduce economic growth in Canada and perhaps push the BoC to hold or even lower interest rates. A lower rate, low energy prices and excess capacity all around do little to support forecasts for higher Canadian inflation.
As a result, there may be bargains to be had in Canada’s bond markets. The RRB market is pricing in a 1.74% Canadian inflation rate, while the BoC target is 2%. Recently, the RRB yield for 20-year bonds has offered a
real return of 0.67%, while a conventional Canada 20-year bond, such as the federal 5% issue due June 1, 2037, was recently priced at $142.14 to yield 2.37% to maturity. Take off the 1.74% implied inflation rate and the real yield is 0.63%; thus, the RRB edges out the conventional bond.
Going out by another decade, the 30-year Canada RRB issued at 1.25% and due Dec. 1, 2047, was recently priced at $116 to produce a real yield of 0.67%, compared with the conventional Canada issued at 2.75% and due Dec. 1, 2048, which was recently priced at $107.63 to yield 2.41% to maturity a real yield of 0.34%. Thus, if inflation is above 1.74% for the period, the RRB will beat the conventional bond. (Note that the inflation rate boost for the additional decade is zero.)
The BoC probably can reflate the Canadian economy to boost inflation, says Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. “The BoC has been successful at managing inflation in the past, and there is no reason to think that [the central bank] cannot levitate inflation upward,” he explains. That, of course, is at the core of the RRB bet.
Given that RRBs are underpriced in terms of what may be future inflation, they should be attractive. Yet, this is a peculiar market. There is a handful of federal issues and a few provincial RRBs. Most RRBs are held by insurance companies and pension funds. Individuals can buy RRBs through an exchange-traded fund and specialty mutual funds.
The combination of pricing RRBs as insurance, plus lack of inflation acceleration in Canada’s economy, left RRBs with negative returns for the two years ended Jan. 31. And note that RRB holders are taxed on interest paid and for price adjustments to pace inflation, even though the bonds may not be sold or income recognized until maturity. Thus, there are both capital and interest taxes. With a conventional bond, a capital gain would not be recognized until sale or maturity of the bond. So, RRBs are best held by patient investors in registered accounts.
RRBs are long bonds and, like all long bonds, have an intrinsic sensitivity to rising interest rates.
“If the entire Canadian bond market heads south because of inflation- driven increases in interest rates, you don’t want to be standing in the way of a sell-off. In that market, only high-yield bonds will likely thrive,” warns Edward Jong, vice president and head of fixedincome at TriDelta Investment Counsel Inc. in Toronto.
The question is: “Which way to turn?” As Benjamin Tal, deputy chief economist with CIBC World Markets Inc. in Toronto, wrote in February: “It is very reasonable to expect the BoC to be on hold in 2017.” That outlook is one reason that inflation premiums for RRBs are modest.
For clients who nevertheless are concerned about inflation rising, the choice is conventional bonds, which will suffer if interest rates rise as they will eventually and alternative debt securities. RRBs can pace inflation, but, as they are long bonds, they tend to drop in price if interest rates rise by more than 2% and tend to thrive in inflationary markets, says Charles Marleau, president and senior portfolio manager with Palos Management Inc. in Montreal.
Marleau says the risks for going long now in a government bond are too great: “Stick with shortduration corporates. If credit spreads shrink, the damage will be limited.”
RRBs are not compelling buys right now. Yet, for inflation protection, they still may offer value.
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