Understanding Real Return Bonds
Real Return Bonds (RRB) are a different type of bond. Their key difference is they offer inflation protection that ordinary bonds cannot provide. Similar to conventional bonds, Real Return Bonds pay out a coupon, but there is an additional bonus as there is an incremental payment based on the level of inflation (CPI).
For example, the 2026 Federal RRBs issue had a basic interest coupon of 4.25%, which is slightly lower than the conventional long bond. The advantage however is that the Real Return Bond value increases based on the CPI inflation rate. This also increases the interest coupon since the coupon rate is multiplied by the higher bond value. The bond is adjusted to inflation quarterly and interest is paid twice a year.
I use the example of a federal government RRB because the federal government issues the majority of Real Return Bonds in Canada.
Real Return Bonds vs regular bonds
(1994 to 2011)
|Year||Bonds||Real Return Bonds|
Why own Real Return Bonds?
- Inflation hedge. The greatest appeal to these bonds is the fact that they are a hedge against inflation. Whatever the inflation rate (measured as CPI), the bondholder will benefit by the same rate. Some people say that real estate or gold are the best inflation hedges but RRBs may be the safest way to build a hedge against inflation.
- Moderate correlation to other bonds. Most investors will need some exposure to bonds or fixed income in their portfolios. However, when you look at the broad category of bonds, it breaks down into some sub categories. There are government bonds, provincial bonds, corporate bonds, and real return bonds. History has shown that RRBs do not move in tandem with conventional government bonds.
- No default risk. Since most Real Return Bonds are government issued, the risk of default is virtually non-existent, making them a very safe way to invest.
- Cash alternative. Some experts argue that RRBs may be a good alternative to holding money market funds. Be careful with this as there are some risks to RRBs which could create negative returns from time to time. While these risks are still low, they are riskier than money markets.
How can you buy Real Return Bonds?
Investors can buy RRBs directly on a retail level. The selection will be limited because the supply of these bonds is limited to begin with. Investors who buy these bonds from investment dealers pay no management fees. However, they will likely pay relatively higher prices than institutional bond investors, whose managers participate in bond auctions to get the lowest price possible.
For most investors, one of the best ways to buy Real Return Bonds is to look at a mutual fund like the TD Real Return Bond fund. With this fund, you get an instantly diversified portfolio of primarily RRBs.
The devil’s advocate
Every investment has good and bad points. As attractive as Real Return Bonds are, keep in mind that they will not do well in deflationary times. It does not look as if we are about to experience deflation in the near future, but this does pose a potential risk.
There are times when RRBs have not performed well. RRBs have underperformed conventional bonds in 8 of the last 18 years. While it does not happen often and losses are minimal, remember that RRBs are subject to some of the normal pressures of supply and demand.
Overall, I think Real Return Bonds are a great diversification tool. Investors looking to add fixed income to portfolios should consider allocating some fixed income holdings to RRBs.
What do you think of Real Return Bonds? Do you own them?