Real Return Bonds

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Shakespeare
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Re: Real Return Bonds

Post by Shakespeare »

Gotta admit 0.6% on the 2021 is hard to take.

OTOH I reduced earlier; it's now only 16% of the portfolio.
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Re: Real Return Bonds

Post by ghariton »

http://www.bankofcanada.ca/en/rates/bon ... of Canada gives the real yield on RRBs as of yesterday as 1.00%, while the yield on nominal bonds of comparable maturities was 3.68%, for a spread of 2.68%. That spread covers two components (1) a liquidity premium, because the market for RRBs is a lot thinner than for nominals (2) a preium to cover the risk of unexpected inflation.

The liquidity premium is usually less, and often much less, than o.1%. It spiked during the Sepgtember to December 2008 liquidity crunch, but I believe that it has returned to normal levels.

Expected inflation over ten to thirty years is hard to forecast, but the Bank of Canada target of 2.0% is probably a reasonable number. I note that the consensus forecast for 2011, as reported by The Economist, is 2.4%.

That leaves a premium for the risk of unexpected inflation, i.e. inflation higher than 2.0%, of 0.7%. Is that a reasonable premium to payÉ That really depends on how risk averse you are to inflation, and what you think the end result will be of the different quantitative easings. But by and large, 0.68% will not make a difference between riches and poverty. Sustained inflation at between 5% and 10%, however, could make such a difference.

But isn`t 1.0% real an absurdly low rate. Itall depends on your point of comparison. For example, nominal government bonds of 1 to 3 years duration, a major building block in the 1 to 5 year usually recommended as a hedge against inflation, average a nominal yield of 1.70%. If you accept my inflation forecasts above, that`s a negative real yield of 0.3% as compared to the long term inflation forecast, and a negative 0.7% as compared to the short-term inflation forecast.

Of course, you could use GICs instead. But this is no better. The Bank of Canada quotes rates as of yesterday of 1.15% for a one year term, 1.43% for three years, and 1.98% for five years, all below the expected inflation rate.

If you want significantly positive real rates, you have to move to corporate bonds, as James Hymas suggests. But then you are exposed to some credit risk. That is a trade-off, of course, and various investors will see it differently. Depending on the corporate issue, you may also be exposed to significant liquidity risk. And remember that, the thinner the market, the greater the spread on these. Of course, you could go to a bond ETF. But then the MER could be significant.

I don`t know much about preferreds, so I won`t comment.

Finally, you can go to equities. That increases expected return, but also risk (pace NormR :wink:). Over the long run, we are told, equities do well against almost all adverse events, and The Triumph of the Optimists seems to bear this out. But if one is retired or about to be, the long run may not matter much.

To summarize, nominal government bonds currently may give good income, but will lkely end up in erosion of capital. Real return bonds will preserve capital, but give a small income. To get both preservation of capital and good income, you have to move to riskier asset classes. Your choice here will very much be a function of your risk tolerance.

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Re: Real Return Bonds

Post by jiHymas »

ghariton wrote:Real return bonds will preserve capital, but give a small income.
This gives rise to thoughts of Sequence of Returns risk. A great deal of the total return on RRBs consists of the increase in principal; many retirement plans accept, implicitly or explicitly, that there will be erosion of capital to some degree, at least in real terms (which nominals have as an intrinsic part of their structure through inflation erosion of the real value of the principal).

It would be most interesting to study the effects of these factors; e.g., if one finds that the ideal allocation to RRBs is X% in a portfolio that seeks to maintain real value, what is the ideal allocation, Y%, for a portfolio in which a decline in value (nominal or real) is accepted? It seems to me that Sequence of Returns risk will serve to encourage Y < X. It's a complex question worthy of careful study.
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Re: Real Return Bonds

Post by Shakespeare »

It's a complex question worthy of careful study
Until then, I'll stick with a rule of thumb: 25% to 75% of my non-equity [i.e. bond, HYB, and cash] allocation in RRBs. Currently I'm just over 25%.
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Re: Real Return Bonds

Post by jiHymas »

ghariton meant to have wrote:Bank of Canada gives the real yield on RRBs as of yesterday as 1.00%
Just realized something that hadn't really hit me before ... if we assume real yields of 1%, inflation of 2% and a marginal tax rate of 40% on income ... then RRBs in a taxable portfolio are cash-flow negative.
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Re: Real Return Bonds

Post by ghariton »

jiHymas wrote:Just realized something that hadn't really hit me before ... if we assume real yields of 1%, inflation of 2% and a marginal tax rate of 40% on income ... then RRBs in a taxable portfolio are cash-flow negative.
Yes indeed. That's why they should never be held outside of a tax-sheltered account such as a RRSP.

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Re: Real Return Bonds

Post by rhenderson »

ghariton wrote:
jiHymas wrote:Just realized something that hadn't really hit me before ... if we assume real yields of 1%, inflation of 2% and a marginal tax rate of 40% on income ... then RRBs in a taxable portfolio are cash-flow negative.
Yes indeed. That's why they should never be held outside of a tax-sheltered account such as a RRSP.

George
I'm obviously missing something here. My marginal rate is 40% and each time that I deregister funds from my RRSP they are taxed at that rate, so what's the difference :?:
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Re: Real Return Bonds

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rhenderson wrote:
ghariton wrote:I'm obviously missing something here. My marginal rate is 40% and each time that I deregister funds from my RRSP they are taxed at that rate, so what's the difference :?:
The problem with RRBs is that a part of the return is in the form of an increase in the principal amount each year, equal to inflation. Unfortunately, you don't actually get that money, in the form of cash, until the bond matures (say in 2021). You do get the semi-yearly coupon, of course, indexed for inflation, but that is only part of the return.

So a part of the return is deferred for ten years or so.

Unfortunately, CRA will tax you each year on the total return -- coupon AND increase in principal. Under plausible scenarios, the tax payable in a given year will actually exceed the coupon received. Thus you have to pay CRA more than you received. That is cash flow negative.

Fortunately, you can avoid this problem by holding your RRBs inside a RRSP or other tax-sheltered vehicle. Here, taxes are deferred until withdrawal from the RRSP. If you hold to maturity and then withdraw or roll over into another investment within the RRSP or RRIF, you will have received the increase in the principal amount before you have to pay taxes on it.

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Re: Real Return Bonds

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rhenderson wrote:I'm obviously missing something here. My marginal rate is 40% and each time that I deregister funds from my RRSP they are taxed at that rate, so what's the difference :?:
While ghariton's explanation is almost certainly correct, I'd explain a psychological problem with your statement. You think the money in your RRSP is your's. If you put it in and take it out with a 40% marginal rate, then the money was never all yours in the first place, but 40% belonging to the gov't. They just lent it to you.

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Re: Real Return Bonds

Post by rhenderson »

George, thank you for the explanation of "cash flow negative". I wasn't aware of the machinations of the RRB's. :thumbsup:

Newguy, I do realise that approximately half of the value of my RRSP is not mine, also makes it psychologically easier to accept a trading loss, oops, just lost half of the government's money :wink:

Whenever I calculate my net worth, I also take this into account.
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Re: Real Return Bonds

Post by big easy »

DavidR wrote:
jiHymas wrote:That being said, it appears that TIPS have a relatively high retail following, just like, for instance, Principal Protected Notes.
Ouch.
jiHymas wrote:It will also be realized that when a government issuer comes to market with TIPS/RRBs, the sales line is "We're from the government, and we're here to help you!" The explicit purpose of TIPS/RRBs is to reduce government funding costs by allowing the government to capture the infation risk premium embedded in nominals.
ouch again.
James,

It's good to have a dissenting voice on this topic and I respect your point of view. At what real yield would you consider RRB's to be a good alternative to corporates?
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Re: Real Return Bonds

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big easy wrote:At what real yield would you consider RRB's to be a good alternative to corporates?
That's a tricky question and one that I consider to be upside down. It implicitly assumes that asset allocation is "bottom-up" whereas I believe that asset allocation should be a "top-down" process, in which an investor chooses his broad asset allocation based on what he wants his portfolio to accomplish.

From this perspective, in broad general terms, one chooses long bonds to provide income-preservation. One very desirable portfolio goal is to insulate your long-term assets from your cash flow requirements, so that you are never in the position of having to sell a long-term asset in order to pay the rent. For instance, a diversified portfolio of long-term corporates can be assembled very easily that has a weighted average current yield of 5.64% and weighted average yield to maturity of 5.38%, prior to deduction of fees of 30bp. Naturally, one can add a portion of preferred shares to this portfolio, but we won't go into that.

So $100 invested will get you $5+ cash every year for a long time. This will be affected, very slowly, by changes in long term corporate yields as components of the portfolio are replaced (naturally, the capital value of the portfolio will change instantaneously with changes in long term corporate yields, but who cares? This is a long term asset); it may also be affected by default. Anyway, this asset will give you 5%-odd cash every year which, in the first iteration, will cover your cash requirements over the medium term.

Need more cash? Well, you're not going to get it while maintaining the same degree of predictability and nominal capital value. Consider an annuity. Need less cash? Great! That gives us a little room to consider other long term assets with a lower cash yield but higher long term expected returns, like stocks.

After the first iteration, you consider your risks. Naturally, a portfolio 100% in long bonds has a high degree of exposure to inflation risk. So you have to address that risk. Maybe you convert a chunk into equities (to address inflation) and an equal chunk into annuities (to replace the cash flow lost when you reallocate from bonds to equities). And you keep on iterating until you're happy that you have a portfolio allocation that covers your personal risks in a manner that is acceptable to you.

When you consider RRBs, though, you have a potential asset with low cash yield (even negative, if held in a taxable account) and a completely unimpressive long-term expected return of (currently) 1%. Equities have a higher cash yield and a higher long-term expected return that should adjust to an increase in inflation.

Having said this, I'll step back a bit:
ghariton wrote:nominal government bonds of 1 to 3 years duration, a major building block in the 1 to 5 year usually recommended as a hedge against inflation,
Not by me. Short term bonds are for liquidity.
ghariton wrote:If you want significantly positive real rates, you have to move to corporate bonds, as James Hymas suggests. But then you are exposed to some credit risk. That is a trade-off, of course, and various investors will see it differently. Depending on the corporate issue, you may also be exposed to significant liquidity risk.
...
Finally, you can go to equities. That increases expected return, but also risk (pace NormR ).
Without meaning any disrespect to ghariton this starts to resemble my least favourite conversations about investments - the topic of risk, imprecisely defined and completely unquantified. Any investment plan can be criticized on the basis of risk. What's the least risky, reasonable, investment? A five year GIC ladder? Tell that to a guy I heard of who caused a scene in a bank back in the mid-90's. His renewal rate was basically half of his old rate and he thought the teller was trying to cheat him. Maybe funny to think about, but this was an old guy and he was going to lose a big chunk of his income - it wouldn't have happened if he'd owned long bonds but I guess somebody told him once that long bonds were risky.

So, to get back to the question about corporate/RRB spreads: well, there's going to be a real yield at which RRBs provide a cash-flow that protects against sequence of returns risk for an "average" portfolio, while also protecting against erosion of capital over the long term and therefore becomes more attractive than long-term corporates as a long-term holding. Say maybe 2.5% real? That gives 4.5% total at current inflation rates and I'm reasonably comfortable - in very broad, general, terms - with paying 100bp (vs nominal corporates) for inflation & default protection. But at that point you're still only getting 2.5% cash return, far less than nominal corporates and merely "competitive" with stocks. I'd guess - totally off the top of my head - that to be competitive with stocks, you've got to get up to 3.5-4.0% real.

But mainly, you've got to plug these things into your own personal situation and remember that expected total return and expected cash return address two very different risks.
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Re: Real Return Bonds

Post by Bylo Selhi »

jiHymas wrote:I'd guess - totally off the top of my head - that to be competitive with stocks, you've got to get up to 3.5-4.0% real.
Caveat: Many of the advocates of RRBs on FWF (including Shakes, Georges, me, et al) bought them when they were yielding 3% to 3.5% real. I can't speak for the others but I'd have a tough time buying them now at 1% real.

Which raises an, um, interesting question: What are RRB holders doing with their interest income, especially those who reinvest it? (I've been buying XSB, waiting for real rates to rise. It's been a long wait :( )
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Re: Real Return Bonds

Post by Shakespeare »

I spend the income. Since my holdings are all in the 2021 4.25%, that means I am slowly spending capital at today's prices.
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Re: Real Return Bonds

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jiHymas wrote:Say maybe 2.5% real? That gives 4.5% total at current inflation rates and I'm reasonably comfortable - in very broad, general, terms - with paying 100bp (vs nominal corporates) for inflation & default protection.
Note also that, assuming a constant Break-Even Inflation Rate of 250bp, this means that long Canada nominals would be trading at about 5%, which is about a 40bp spread vs. long corporates, which is a generous, but not ridiculous, allowance for default risk.

In other words, I'm not willing to pay much liquidity premium at all, if any. Why should I, if the intent is to have and to hold, from this day forward, 'till death do us part? We're not talking about a big institutional portfolio that needs to trade $20-million at a time.
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Re: Real Return Bonds

Post by jiHymas »

Bylo Selhi wrote:Caveat: Many of the advocates of RRBs on FWF (including Shakes, Georges, me, et al) bought them when they were yielding 3% to 3.5% real. I can't speak for the others but I'd have a tough time buying them now at 1% real.
Those who bought at 3% to 3.5% real have, of course, done very well over the holding period (the last time I see these numbers are the summer of '03). And I can well believe that I might find little to criticize in a financial plan that included an allocation to RRBs when bought in that range.

However, circumstances alter cases. You made a good decision and results have not simply met the plan, but the financial markets have handed you a gift. I would consider it quite prudent and logical to build a new financial plan using today's prices and then examining the transaction costs to see if switches will improve your portfolio (given the names you mentioned I'm sure this is routine; but it's always worth while to point out).
Bylo Selhi wrote:(I've been buying XSB, waiting for real rates to rise.
This, however, is market timing, which I consider ... less prudent and logical.
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Re: Real Return Bonds

Post by Bylo Selhi »

jiHymas wrote:This, however, is market timing, which I consider ... less prudent and logical.
Guilty as charged, your honour.
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Re: Real Return Bonds

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Bylo Selhi wrote:What are RRB holders doing with their interest income, especially those who reinvest it? (I've been buying XSB, waiting for real rates to rise. It's been a long wait :( )
I've got the amount of RRBs my plan calls for. I topped up in the fall of 2008 when the real yield was over 2% (2.5% if I remember correctly). So the interest goes to other things -- mostly REITs in the past few years, now to U.S. equities.

I think risk is a subjective thing, and highly personal. I know that I could earn a higher return if I made alternative investment choices. But I would then feel exposed to tail risk. In the present case the tail risk I am addressing is sustained inflation at 5% to 10% for a period of five to ten years. If that happens, there is a good chance, in my opinion, that realized real returns on both nominal bonds and equities would be negative. As for commodities, I don't know. But I would feel uncomfortable relying on them to any extent.

The analogy I draw is to the 1970s. The probability of stagflation returning may not be high, but it's not negligible, either.

But then, differences in views is what makes securities markets tick.

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Re: Real Return Bonds

Post by big easy »

James,

Thank you for your detailed and well-thought out response. To be honest, long term corporates are/were completely off my radar.
jiHymas wrote:After the first iteration, you consider your risks. Naturally, a portfolio 100% in long bonds has a high degree of exposure to inflation risk. So you have to address that risk. Maybe you convert a chunk into equities (to address inflation) and an equal chunk into annuities (to replace the cash flow lost when you reallocate from bonds to equities). And you keep on iterating until you're happy that you have a portfolio allocation that covers your personal risks in a manner that is acceptable to you.
My approach has been to rely on equities to generate real returns and to offset this will ST bonds and RRB's to provide liquidity, inflation protection and to limit downside risk. When equities go wonky, I rebalance. The RRB's and ST bonds let me sleep at night. During the lastest market fiasco, my portfolio lost something like 20%. I suspect a portfolio of long term corporates and equities would have fared much worse. During the latest crash I slept well, I did not panic and was able to rebalance into equities. I doubt that would be the case if I was holding LT corporates instead of XSB/RRB.

Having said that, your arguments have me reconsidering (to some extent) my philosophy. Having half one's portfolio in low return investments puts a heavy burden on the rest of the portfolio. (Also, I've probably overestimated the probable returns available from equities). A small dose of long/midterm corporates (RRSP) and preferreds (taxable account) may be in order.

When I look back, I have spent the past twenty or thirty years investing to avoid inflation risk. Does the continuous fall in interest rates finally have me capitulating? So back to the fear side of the equation - is this the worst possible time to invest in long term bonds and perpetual preferreds?

BTW, my RRB's were bought at a 2% real yield. I'm really torn about selling them. According to this http://www.bogleheads.org/wiki/Historic ... ed_Returns the real return on US long term corporates is around 3% real. So I am giving up 1% but have virtually zero risk if held to maturity. OTOH I have a nice capital gain and real yields are bound to go up again aren't they :? ?
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Re: Real Return Bonds

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big easy wrote: My approach has been to rely on equities to generate real returns and to offset this will ST bonds and RRB's to provide liquidity, inflation protection and to limit downside risk. When equities go wonky, I rebalance. The RRB's and ST bonds let me sleep at night. During the lastest market fiasco, my portfolio lost something like 20%. I suspect a portfolio of long term corporates and equities would have fared much worse. During the latest crash I slept well, I did not panic and was able to rebalance into equities. I doubt that would be the case if I was holding LT corporates instead of XSB/RRB.
Don't sell the approach short until you have tried it. In 2008 the taxable portion of our portfolio that contains predominantly common stocks, but also a fair allocation to preferred shares (as a proxy to long term corporates) dropped <15%. This was further enhanced by the positive returns on our registered accounts that are entirely fixed income (laddered out to 12 years with a bias to corporate issues) resulting in a livable return for the year that was ~-11%. This was from an overall allocation that was approximately 55:45 equity:fixed income. It was a busy time for me from an activity perspective as I was crystallizing losses through trading of closely related issues, but there wasn't a wholesale rebalancing to equities as I wasn't prepared to sell bonds before they matured and endure the hefty discounts at the time, but I doubt that had a material impact on my returns since as corporate credits of all stripes have performed marvellously.
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Re: Real Return Bonds

Post by jiHymas »

big easy wrote:BTW, my RRB's were bought at a 2% real yield.
Yes, but those are yesterday's prices.
big easy wrote:According to this http://www.bogleheads.org/wiki/Historic ... ed_Returns the real return on US long term corporates is around 3% real.
I suggest that rather than look at historical returns and dated punditry, you gauge the expected nominal return on long-term US corporates from Vanguard's Long Corporate ETF (symbol:VCLT), which is now 5.8% and subtract your inflation expectations.
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Re: Real Return Bonds

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How Inflation-Protected Funds Get to Inflate Their Yields
Among the 173 TIPS mutual funds tracked by Morningstar, the reported "SEC yields" as of March 31 ranged from minus-0.77% to 5.58%, with 12 funds yielding at least 5%. Four of the seven exchange-traded funds that specialize in TIPS displayed yields greater than 5%, with Pimco 15+ Year U.S. TIPS Index leading the pack at 6.07%.

Yet no TIPS yield more than 1.75%. How could anyone but an alchemist generate 5% or more out of 1.75% or less?

The answer lies hidden in the term "SEC yield." In 1988, the Securities and Exchange Commission forced funds to include only dividends and interest income in the yield that they must show investors.

The return on TIPS, however, comes not just from interest income but also from any adjustment in value as inflation rises.

The SEC hasn't issued any guidance to fund companies on how to handle this peculiarity when they show standardized yields, says Gene Gohlke, associate director for examinations at the agency. As a result, firms are free to do more or less as they please, without running afoul of the rules...

The bottom line: While the SEC yield is a decent guide in other bond funds, it can steer you wrong in an inflation-protected bond fund. Before buying a TIPS fund, ask instead what its real yield is.

SEC yields "are like the square root of negative-1 in algebra," says bond expert Frank Fabozzi, a finance professor at Yale University. "They give you an imaginary number."
Is there a similar "OSC yield" for RRB funds that provides similar obfuscation opportunities?
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Re: Real Return Bonds

Post by jiHymas »

Bylo Selhi wrote:Is there a similar "OSC yield" for RRB funds that provides similar obfuscation opportunities?
Yes. Money Market Funds are permitted to price their holdings based on historical cost with a straight-line amorization of the discount.

However, there is no similar requirement for yield reporting for longer-term bonds of which I am aware. Dealers are permitted to quote yields on sub-debt based on maturity five years prior to the bond's actual maturity, for example.

I have seen many interesting methods used to calculate yields on strips.

I haven't noted any particular abuses with RRBs specifically, but I'm sure they could be found.

In your quotation, it should be noted that the penultimate paragraph conflicts with the last with respect to "normal" bonds. It is the last one which is accurate: SEC Yields are Just Plain Dumb.
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Re: Real Return Bonds

Post by big easy »

Shakespeare wrote:Gotta admit 0.6% on the 2021 is hard to take.

OTOH I reduced earlier; it's now only 16% of the portfolio.
A week and a half later and now it's 0.48% on the 2021. Is that a misprint? :shock:

http://www.globeinvestor.com/servlet/Pa ... ype=fedgov

Check this chart:

http://www.canadianbondindices.com/data/RRB_TR.jpg
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Re: Real Return Bonds

Post by Bylo Selhi »

big easy wrote:A week and a half later and now it's 0.48% on the 2021. Is that a misprint?
Well you could buy the 2021 residual, avoid reinvested interest rate risk, and get 33% more interest (0.64% real) :twisted:
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