Real Return Bonds

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ghariton
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Re: Real Return Bonds

Post by ghariton »

newguy wrote:I also like to see the difference between the two series as one proxy for inflation expectations.
The difference reflects expected inflation, but it also includes a risk premium (to cover the risk of unexpected inflation) and a liquidity premium (because there are fewer RRBs out there than nominals). Usually the riak premium is pretty stable over time and the liquidity premium is so small as to be negligible -- but not always.
So what do you think is driving the yield spike, real or nominal rates or declining inflation expectations? I know it's all related but I've read a few stories that say it's driven by a change in real rates.
Yes. The graphs are showing a bigger increase in real rates than in nominal rates. If anything, inflationary expectations are declining a bit. Both of these would be consistent with a phasing out of QE and of Abenomics (as you point out). There is also the torrent of recent commentary, suggesting that investors bail out of bonds.

We all know that interest rates will rise in the long run. However, I expect a very gradual increase. I think that what we are seeing these last couple of days is a temporary blip, as investors try to get ahead of the curve, i.e. anticipate future increases.

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poedin
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Re: Real Return Bonds

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George$ wrote:
poedin wrote:So ... if one was looking to further diversify their fixed income portion of their portfolio, then this would not be an opportune time to buy RRBs at their current real yield? Perhaps a patient 5+ year buy in approach?
It depends (from my perspective). Let me illustrate with the following two extreme positions.

Individual #1 - age 60+, out of work with little prospect of future employment, with preservation of savings a paramount concern, not willing to roll the dice and so perhaps diminish the savings in hand, worried about inflation increasing, etc. This individual should find the 1% RRB attractive.

Individual #2 - age 30 with an education who is not worried about asset preservation at this stage of his life. Realizes that he can take some risks, as he has 30+ years to recover should his investments stumble, etc. This individual may not be interested in a 1% real return, albeit very safe, via RRBs.

Just my opinion.

The gray area between #1 and #2 is where it becomes difficult to know what to do with RRBs.
Currently I can identify myself more with #1.
With yields now ~1.31
http://www.bankofcanada.ca/rates/intere ... ian-bonds/
wouldn't this be a better time to initiate some buys?
[disclosure: newbie to RRBs, patiently waiting since 2011 to diversify FI component of portfolio]
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Re: Real Return Bonds

Post by jay »

poedin, I am in the same boat. I am hoping it gets to 2% before I start jumping in.
RRBs and long term nominals are down ~15% or so. That is as bad as 1994, the worst year for bonds in the last 30-40 years. Or is it not?

Shakes: what is your take on RRBs?
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Re: Real Return Bonds

Post by Shakespeare »

Who knows? But I'm not optimistic about seeing 2%.
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Re: Real Return Bonds

Post by mr_l »

Hi,

Can someone explain how I would go about filing taxes for RRB held in an unregistered account using UFile?

finiki:
Like nominal bonds, RRB interest is taxed as ordinary income at your marginal tax rate. Inflation adjustments are also taxed annually as ordinary income as they accrue even though you won't receive them until the bond matures, possibly many years later. This tax treatment means they should be held in registered accounts, such as a Registered Retirement Savings Plan, Registered Retirement Income Fund or other tax sheltered accounts..
So how do I go about (1) calculating the inflation adjustments on my capital and (2) reporting it to CRA via UFile?

Scenario
Say I paid $39,000 on Jan 2, 2013 for 20,000 units of Dec 2021 RRB via TDW.

(1) Calculate Inflation Adjustment on my Capital
Assume CPI_Dec2013 = 123.0 (not posted yet). CPI_Dec2012=121.2. CPI_base=83.07713 (Thanks RRB.xls!)
a)Do I find $20,000 face x (CPI_Dec2013/CPI_Base - CPI_Dec2012/CPI_Base) = $433.332254 ?
b)Or do I need to account for the amount I paid ($39,000): $39,000 book x (CPI_Dec2013/CPI_Dec2012 - 1) = 594.044554
c) Or am I way off?

(2) Reporting Capital Inflation to CRA via UFile
So assume I can resolve #1, say I know my capital's (nominal, not real) value has increased by $433.33 in 2013. Where do I report this in UFile? Should I just add it in to my interest received from the RRB? I am pretty clueless on taxes.

Help much appreciated! I didn't see any examples of dealing with the taxes when I searched, but if I missed a resource please point me in the right direction! I think I get how the CPI values increase interest payments and the principle paid at maturity, and figure reporting interest payments will be done via T-slips TDW sends me, but need help with this annual reporting of capital inflation.

Thanks,
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Re: Real Return Bonds

Post by Peculiar_Investor »

For those interested, the taxation discussion continues in Real Return Bonds: annual tax
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Re: Real Return Bonds

Post by SoninlawofGus »

What am I missing? CPI averaged around 2% for the year. The RRB index ratio was around 1.51 for June and December. I received $320 for the year for 5000 units of the Dec 2021. Where I'm confused is my actual yield that I received, which works out to about 3.4% for the year. It seems too high. With CPI around 2% and the bond essentially a 7-8 year real yield of almost 0%, why would I be receiving $320 on an RRB with a current value of around $9720 (it was $9433 a year ago)? I guess what I'm asking is, of the 3.4% I received, what amount is attributable to the real yield?
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Re: Real Return Bonds

Post by Shakespeare »

Some of it is ROC as the coupon yield (4.25%) exceeds the current YTM.
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Re: Real Return Bonds

Post by SoninlawofGus »

Thanks, although I'm trying to get my head around that concept. If I'm receiving ROC with each payout, is that effectively cutting into the underlying value of the bond? I'm not sure how to ask the question. Going forward, will the current market value of the bond at least track inflation or not?
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Re: Real Return Bonds

Post by Shakespeare »

It's premium bond trading above par. Real YTM is close to zero. That means you will get the CPI and little else.
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Re: Real Return Bonds

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SoninlawofGus wrote:Thanks, although I'm trying to get my head around that concept. If I'm receiving ROC with each payout, is that effectively cutting into the underlying value of the bond? I'm not sure how to ask the question. Going forward, will the current market value of the bond at least track inflation or not?
The RRB 2021 is a premium bond currently, i.e. the coupon rate is higher than the market yield. It follows that the market value is higher than the face value. Here, I mean the face value adjusted for cumulative inflation since issue. After all, the 4.25% coupon is based on this adjusted face value.

As stated upthread, the market yield is 3.4% and the coupon is 4.25%. The difference is return of capital, which you receive every six months. This serves effectively to decrease the market price a bit (again, this is after adjusting for inflation). This is not easily seen because there are fluctuations in other determinants of market value, e.g. changes in real interest rates. But over time, the market value is on a glide path toward the face value, adjusted for cumulative inflation. At maturity, the two will be roughly equal.

So upon maturity you will receive the face value plus accumulated inflation. In the meantime, you will receive the coupon adjusted for cumulative inflation. This latter is made up of the market yield, plus a return of capital to reflect that this is a premium bond (and commands a price higher than face value, increased by cumulative inflation).

Dunno if that helps.

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Re: Real Return Bonds

Post by SoninlawofGus »

ghariton wrote:But over time, the market value is on a glide path toward the face value, adjusted for cumulative inflation. At maturity, the two will be roughly equal.

So upon maturity you will receive the face value plus accumulated inflation. In the meantime, you will receive the coupon adjusted for cumulative inflation. This latter is made up of the market yield, plus a return of capital to reflect that this is a premium bond (and commands a price higher than face value, increased by cumulative inflation).

Dunno if that helps.

George
Dunno. :P Yeah, it does help some, thanks. I based a lot of my original thinking on Bylo's RRB site, but ROC is not mentioned there.

So, is "face value plus accumulated inflation" equal to face value x the index ratio? In this case, today, that would be roughly 5000 x 1.515 = $7575.

Lately, I've been wondering why the government does not just offer a plain vanilla inflation-only bond (preferably in addition to the RRBs). No real/long yield. That would be a lot simpler to understand, and it wouldn't be possible to lose money with that.
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Re: Real Return Bonds

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SoninlawofGus wrote:So, is "face value plus accumulated inflation" equal to face value x the index ratio? In this case, today, that would be roughly 5000 x 1.515 = $7575.
Yes.
Lately, I've been wondering why the government does not just offer a plain vanilla inflation-only bond (preferably in addition to the RRBs). No real/long yield. That would be a lot simpler to understand, and it wouldn't be possible to lose money with that.
If I interpret your suggestion correctly, that wouldn't be a bond, that would be insurance against inflation. Some products along these lines already exist, at least in the U.S. But I wouldn't describe them as easy to understand.

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Re: Real Return Bonds

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ghariton wrote:
Lately, I've been wondering why the government does not just offer a plain vanilla inflation-only bond (preferably in addition to the RRBs). No real/long yield. That would be a lot simpler to understand, and it wouldn't be possible to lose money with that.
If I interpret your suggestion correctly, that wouldn't be a bond, that would be insurance against inflation. Some products along these lines already exist, at least in the U.S. But I wouldn't describe them as easy to understand.
I would think I-bonds fit the T-bill nicely. Series I Savings Bonds

My understanding is that because Ottawa no longer relies on savings bonds to raise meaningful amounts of money(*) there's little reason for them to consider I-CSBs.

(*) Except from suckers who don't realize they can get better rates from any CDIC insured bank. They're probably the reason why CRA has a line on the tax return for making voluntary payments to the crown.
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Re: Real Return Bonds

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ghariton wrote:
SoninlawofGus wrote:So, is "face value plus accumulated inflation" equal to face value x the index ratio? In this case, today, that would be roughly 5000 x 1.515 = $7575.
Yes.
Hmmm, so if inflation were to go to 0 tomorrow, then the index ratio would remain constant. I would get my $7575 in 7 years, and I would get the $320ish a year in interest. Although that would be fine, and it all makes sense, it's somehow not how I imagined it (I mostly hold strips, which clouds my thinking). I think, for me, a RRB strip bond would have been better for me from a intuitive perspective. But, I see now, those are illiquid and hard to find.
Bylo Selhi wrote: I would think I-bonds fit the T-bill nicely. Series I Savings Bonds
Those sound a lot like RRBs to me: fixed return + semiannual yield. I was thinking of something that merely tracked inflation, paid at whatever interval. If it paid annually, you'd just get the average or median rate for the year. What would be even better would be a money market or HISA type of thing. Granted, nobody would give us that today!
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Re: Real Return Bonds

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I've been thinking about RRBs lately, and their suitability during the accumulation stage. If an investor buys them through an ETF, he will see wildly fluctuating yearly returns, because the weighted average maturity is very long (19.5 yrs for XRB, the Ishares real return bond ETF, compared to 10.4 yrs for XBB, the broad market nominal bond ETF, or 2.9 yrs for XSB, the short bond ETF). Over the period 1993-2013 (Libra data), the standard deviation of RRBs was about 10%, compared to 6% for broad market nominal bonds and 4% for short bonds.

Say we start w/ a balanced portfolio with 50% nominal broad market bonds and 50% stocks (which stocks in particular does not matter). The weighted average maturity of the bond portion is 10.4 years (based on the current value for XBB), and the stdev is 5.8% for the bond portion (based on the past). We want to keep the weighted average maturity and stdev constant. Within the bond portion, a mix of about 45% RRB and 55% short bonds would do that (this translates into about 22% RRB and 28% short bond on a whole portfolio basis). The stdev calculation takes into account the 0.49 correlation coefficient btw RRBs and short bonds during the examined period.

The returns of the RRB-short bond mix, however, were a bit less than for broad market nominal bonds, the default choice: 6.4% for the mix vs. 7.0% for the broad market nominal bonds (again, for the period 1993-2013). On a whole portfolio basis the difference is -0.3%. This can be seen as the price of an insurance policy against unexpected inflation: over the previous two decades, inflation was well controlled, and RRBs were not especially useful. You "paid" 0.3% for insurance against an event (unexpected inflation) that did not occur. But we don't know about the future: maybe the house will eventually burn down (unexpected inflation will occur), and the insurance policy holders (the purchasers of RRBs) will be rewarded?

Is that a good way to think about RRBs in balanced portfolios?
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Re: Real Return Bonds

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Quebec wrote:Is that a good way to think about RRBs in balanced portfolios?
I haven't checked your numbers. But yes, that seems reasonable to me.

I personally use an estimate of 0.5% to 0.8% as the cost of insurance against unexpected inflation. This is roughly consistent with estimates published by the Federal Reserve Bank of Cleveland for U.S. TIPS. I note that these correspond to your 0.6%, not your 0.3%.

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Re: Real Return Bonds

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My apologies if this is obvious to everyone thinking about holding RRBs and buying them at premium.... keep in mind that if they are in a taxable account, the taxes are quite unfavourable because these bonds sell at such a premium (since issued when rates were higher). You get taxed on 100% of the interest payments but can only include 50% of the eventual capital loss (worse yet, there may not even be a loss once it matures due to the inflation adjustment). So if you are REALLY worried about mass unforseen inflation than consider RRBs as part of your portfolio... but realise that you may end up with a negative return when all is said and done.
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Re: Real Return Bonds

Post by Bylo Selhi »

mr_l wrote:keep in mind that if they are in a taxable account, the taxes are quite unfavourable...
It's actually even worse than that. There are also regular CPI inflation adjustments on the principal. In taxable accounts these are taxed every year as they accrue even though you may not see the cash for up to 30 years when the RRB matures. This is why RRBs and RRB bond funds/ETFs should be held in a tax-deferred or tax-sheltered account like RRSP or TFSA.
realise that you may end up with a negative return when all is said and done.
This is true of all bonds, whether or not they sell at a premium. It's the price you [may have to] pay for the security and diversification of including them in your portfolio.
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Re: Real Return Bonds

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Bylo Selhi wrote:There are also regular CPI inflation adjustments on the principal. In taxable accounts these are taxed every year as they accrue even though you may not see the cash for up to 30 years when the RRB matures.
Such a worthwhile point that it needed to get added to the wiki, see Real Return Bonds.
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Re: Real Return Bonds

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Quebec wrote: On a whole portfolio basis the difference is -0.3%
Another thing not included in my analysis unthread is that the MER for real return bond ETFs is higher than the MER on broad market nominal bond ETFs, e.g. about 0.4% for XRB compared to 0.1% and change for the Vanguard Canada nominal bond ETFs. So my hypothetical 20-25% RRBs would add another 0.1% to the costs of a balanced portfolio. We're getting near a 0.5% drag on expected returns, if there is no unexpected inflation. So how much do we trust the Bank of Canada to control inflation? Has the beast been definitely tamed?

(yes I could buy individual RRBs instead of ETFs but probably not at Questrade. Questrade has free ETF purchases so I'm staying there for now)
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Re: Real Return Bonds

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Peculiar_Investor wrote:
Bylo Selhi wrote:There are also regular CPI inflation adjustments on the principal. In taxable accounts these are taxed every year as they accrue even though you may not see the cash for up to 30 years when the RRB matures.
Such a worthwhile point that it needed to get added to the wiki, see Real Return Bonds.
Thanks.

To nit-pick my own words, this assumes inflation. During a period of deflation the adjustment would be negative. I'm not sure how that would be taxed. Presumably it would be a loss of some sort to compensate for some of the tax paid on accruals from previous years.

Unlike US TIPS there's no floor on the principal value paid at maturity. So if there's sustained deflation during the life of an RRB the principal value paid at maturity in future dollars could be less than face value. Presumably that would constitute a capital loss. This gets even more complicated if you buy and sell before maturity, especially if some of the adjustments are treated as interest and others as capital. Yet another reason not to hold this stuff in taxable accounts.
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Re: Real Return Bonds

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Wow yields have really fallen off a cliff: 0.28% on the 2041 RRB, 2.02% on a 2045 nom. Gov Cda, 1.42% on a 10 yr Gov Cda, 0.74% on a 5 year. Its going to be hard to roll over those GIC ladders.
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Re: Real Return Bonds

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big easy wrote:Wow yields have really fallen off a cliff: 0.28% on the 2041 RRB, 2.02% on a 2045 nom. Gov Cda, 1.42% on a 10 yr Gov Cda, 0.74% on a 5 year. Its going to be hard to roll over those GIC ladders.
Down again today, across the yield curve (using Bank of Canada web site).

Nominal long term government bonds, 1.93, RRBs 0.23, for a spread of 1.60%. That covers expected inflation, a risk premium for unexpected inflation, and a liquidity premium (which I set at zero for convenience). If you think that the risk premium for unexpected inflation is 0.5%, then expected inflation is 1.1% over the next 30 years. I think that is ridiculous.

If I were a trader (which I'm not) I would go long RRBs and short nominals of the same duration. That would largely immunize me against the risk of movement in real interest rates, leaving a pure play that inflation will average more than 1.6%, or rather that perceptions of expected inflation will be more than 1.1%.

Rather than trading the bonds themselves, I suppose it would be better to trade bond futures. Are there futures on RRBs, and if so, how do they trade?

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Re: Real Return Bonds

Post by SoninlawofGus »

Negative yields are the trend now. And I sold our long bonds just in time to miss the recent run up. :( Still holding some RRBs, but only the 2021s.

There are still gains to be made if you believe they will keep going lower (-2% anyone?), or is it just the greater fool theory at this point?
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