© Copyright 2002 Rogers Media. The following article first appeared in the March 2002 edition of BENEFITS CANADA magazine.

Real-return bonds ought to be a defined benefit plan manager's dream in this economy. They are guaranteed to keep pace with increases in the Consumer Price Index (CPI). As a result they eliminate much of the guesswork involved in estimating future interest rates and offer what amounts to automatic indexation to the CPI. Yet, in spite of their inflation-fighting benefits, real-return bonds remain an obscure investment.

Three outstanding federal real-return bonds issued in 1991, 1995 and 1999, totalling less than $14 billion, (just one conventional bond issue) set the tone of the market, says Paul Gardner, vice-president and director of TD Asset Management Inc. in Toronto and co-manager of TD's Real Return Bond Fund.

The federal issues currently pay about 3.7%, plus an adjustment for changes in the CPI. With a 2% estimated annual CPI index adjustment based on the Bank of Canada's target inflation rate, these federal real-return bonds have an effective yield of about 5.72%, close to the 5.66% yield on the 5.75% Canada, which matures on June 1, 2029.

Several provincial issues, including a public Quebec tranche and two Quebec private placements (Strait Crossing Finance Inc. and 407 International Inc.) round out the Canadian basket of real-return bonds. But only the federal issues are currently traded, so pricing is not available for the provincial issues.

In private portfolio management, real-return bonds turned out to be winners last year. Mutual fund expert Gordon Pape awarded the title of 'Bond Fund of the Year' to the TD Real Return Bond Fund in his 2001 Buyer's Guide to Mutual Funds. With a total return of 15.7%, this fund was the strongest player among Canada's 210 bond mutual funds that produced a comparatively meagre median gain of 8.5% last year.

Pape appears to have been correct in commenting that the fund's flourish of high returns was short lived. With $94 million in total assets as of July 31, 2001 it was down 1.7% for the three-month period ending on that date, compared to an average loss of 0.1% for all Canadian bond mutual funds. The reality is that real-return bonds feed on inflation and when inflation drops, so do their returns.

Real-return bonds can easily protect individual retirement accounts from inflation, but pension fund managers see them in a different light. Institutional portfolios predict future returns decades in advance, and that requires making some assumptions on inflation rates. But the need for macro forecasting is not distinct to real-return bonds. Any manager of a long-bond portfolio has to make some implicit estimates of what lies ahead.

What makes real-return bond cash flows problematic is their lack of fixed and known payouts. While they guarantee future purchasing power in CPI terms, their cash coupons are unknown. That makes them impossible to price accurately with discounted cash-flow models.

The tax status of real-return bonds complicates matters. According to the Bank of Canada, real-return bond holders are taxed on a cash basis for coupons received in each tax year rather than on an accrual basis. Investors are taxed, not only on interest paid, but on changes in the adjusted-cost base of the bonds. If the bonds are revalued upward to accommodate higher inflation, then the change in the price of the bond reflected in the adjusted-cost base is taxable.

These difficulties are the main reason why institutional investors shun real-return bonds, says Robert Marcus, managing director of Altamira Investment Services Inc. in Toronto. "Real-return bonds are illiquid," he adds. "You can't short these bonds because there is nothing to hedge them against. So no one running a bond fund will buy them unless they plan to hold them to maturity."

Another mark against real-return bonds lies in their classification. They are so different from other assets in terms of economic sensitivity and their direct link to inflation that they can be considered a class of their own, says Roger Quick, fixed income analyst at Scotia Capital in Toronto. "Their payouts rise with inflation, unlike any other security," he says. Yet they are not fully protected. "Real-return bonds present market risk because if there is a rise in interest rates without a corresponding rise in inflation, prices will go down."

Despite these complexities, real-return bonds do offer an advantageous return under certain conditions--especially when they have a current payment advantage over conventional bonds. Is it rational, then, for investors to avoid what appears to be a sure winner when inflation is rising?

In a recovery, which many economists are forecasting for later this year, consumer prices and interest rates will once again head upward. In fact, the Bank of Canada is set to meet March 5 and bets are out that there will be no more cuts in interest rates.

THE DEFLATION FACTOR
Even if real-return bonds make sense under certain sets of assumptions, a sense of pride in their own financial workmanship may drive professional investors away from real-return bonds, says Marcus. After all, it is difficult to calculate durations on bonds that have indefinite payouts. As well, since real-return bonds reduce their payouts in the event of deflation, they are less appealing than conventional bonds with fixed coupons.

If deflation were to occur, conventional bonds would rise in price as their fixed coupons gain in purchasing power. But real-return bonds would suffer falling payouts and would not rise in step with fixed coupon bonds.

But inflation-indexed debt instruments are not necessarily penalized by deflation. In the U.S., inflation-indexed securities, known as treasury inflation protection bonds (TIPs), were introduced in January 1997. They are believed to have been modelled on Canadian real-return bonds. The value of TIPs are adjusted daily based on the CPI for Urban Consumers. If inflation rises, TIPs' principal value rises with them. Payouts are set at fixed amounts at the time of issue.

Unlike real-return bonds, TIPs will not decrease in value below the initial sale price of the bond in the event of deflation. However, the revaluation of principal produces a notional capital gain during periods of inflation. The bondholder is taxable on the book gain that is effectively priced to market, even though there is no payout of the actual gain until maturity. The tax treatment is like that of a stripped coupon held in a taxable account.

In Canada, real-return bonds have performed better than many recognize. In spite of a recent drop in performance, they have been among the strongest bonds in the world over the last two years, says Gardner. "As world central banks reflated their economies following the 1998 Asian currency crisis, CPI numbers have risen. Today, rising energy prices have boosted the CPI."

Gardner argues that soaring tobacco taxes and housing prices drive up the CPI and make a strong case for owning real-return bonds. While there have been periods in which energy prices have decreased over the past year, Gardner dismisses this as "a short-term negative for these bonds."

Last year, the U.S. Federal Reserve dropped U.S. short-term interest rates to a level not seen in decades. There may be more cuts to come. A return to higher inflation in the U.S. and Canada will take place as the economies of the two countries recover from market volatility exacerbated by the shock of Sept. 11. But recovery is expected to be slow, says Scotiabank economist Aron Gampel.

Scotia Capital is predicting a 2% increase in consumer prices in 2002. That's down from 3% growth last year and 2.7% in 2000. This suggests that the appeal of real-returns bonds will decline this year.

"If you think that inflation is going to pick up, get inflation-protected bonds," advises Bob Alley, senior vice-president and chief fixed income officer for AIM Capital Management Inc. in Houston. "If you think inflation is going to rise slowly, stick with conventional bonds."

It is also important for institutional investors to watch the gap between payments on real-return bonds and conventional bonds. In their illiquid market, real-return bonds can pay as much as 75 basis points more interest than federal bonds of similar maturity, says Gardner. Liquidity and administrative difficulties aside, that premium return is hard to match. BC

Andrew Allentuck is a freelance writer based in Winnipeg. ajames@total.net.

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