Park wrote: But 1-5 year (short term) inflation indexed bonds may be the best of a not so good bunch. However, 10+ (long term) inflation indexed bonds don't correlate with inflation well; I presume that's due to interest rate risk.
Yes, there is real interest rate risk and RRBs don't cover it off. But that isn't due to inflation. It's due to the business cycle and all sorts of other (real) factors. Nominal bonds are subject to all those factors AND inflation risk
Only long term Canadian inflation indexed bonds are issued.
Yes. On the other hand, a certain amount has been stripped, and in theory you can buy just the coupons. (I say "in theory" because most of the coupons are being held to maturity by buy-and-hold investors and institutions.)
The shortest-term RRBs available, maturing in 2021, have a duration of some nine years (measured in real terms). That means that, if real interest rates increased by 200 basis points today, you would lose 18% of the market value of the bond. I would take that as the extreme scenario.
Even that assumes that you want, or have to, sell the bond today. If you hold to maturity, the interest rate risk gradually disappears and goes to zero. Most of the holders of RRBs do intend to hold to maturity, and so interest rate risk for us is not an issue.
Even then, not many are issued, which raises liquidity concerns.
Yes, this is a concern, especially with strips. Normally, however, the liquidity premium for RRBs over nominals is small and has been measured (however imperfectly) at about 10 to 15 basis points. I note that even at the worst of the liquidity crunch in the fall of 2008, when liquidity premiums skyrocketed, the total real return peaked at about 2.7% to 2.8%. Again, the duration of the 2021 bond suggests a loss in market value of less than 20% even during this kind of crisis.
Again, if you're holding to maturity, liquidity doesn't matter.
I think this is an important difference for Canadian investors. We get advice from American sources recommending inflation indexed bonds. That advice is intended for American investors. But American investors can buy short and intermediate term inflation indexed bonds, and have to worry about liquidity less.
The counterargument would be that if you buy and hold individual Canadian inflation indexed bonds (real return bonds, RRBs), then you do get a perfect inflation hedge. But if you're getting RRB exposure through a mutual fund or ETF or do not keep individual RRBs until maturity, then the above post is relevant.
Exactly.
Of course, I think that holding RRBs through a mutual fund is foolish. The last time I looked at the TD Waterhouse one, itys MER was over 1%. An ETF like XRB is slightly less foolish, and may make sense if you're investing small sums. Otherwise, I really don't see why one would not hold individual RRBs, with maturities tied to one's life expectancy or other spending needs.
BRIAN5000 wrote:According to another PDF posted by ig17 this is only true if your individual inflation rate is the same or similar to the CPI and you hedge the correct amount.
True.
Statistics Canada has measured the inflation experienced by the average Canadian senior. While the rate does diverge from the total CPI from year to year, over periods of five years or more, the two end up quite close for Canada. (Things may be different in the U.S. because of the way that their health care system is funded.) But those are still averages, and individuals do differ.
I haven't seen studies on this, but I suspect that other inflation hedges would track individual experiences of inflation much less closely than the CPI. Certainly that would be true for me according to my present spending patterns. (If you want to see how well the CPI tracks your spending patterns, look at the weights that Statistics Canada uses and compare them to your personal expenditures.)
"What is the best hedge against inflation? CASH!!"
I'm puzzled by this paper, which actually looks like a chapter for a forthcoming book.
Put aside that when the author says "Cash" he means U.S. Treasury Bills. And put aside that there are no references or sources for the claims or the data.
The author makes much of the fact that the correlation between TIPs and inflation was 0.10 from 1997 to 2011, and 0.16 from 2011 to 2011. But those seem to be pretty short time periods for any serious analysis, especially given that 2008 and 2009 were not exactly typical years. I call statistical abuse.
George