Real Return Bonds

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ghariton
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Re: Real Return Bonds

Post by ghariton »

brucecohen wrote:Also note that the standard 5-year GIC ladder offers an annual opportunity to adjust 20% of the ladder for the then-current outlook for inflation.
True. These days, people who are following this strategy, for the most part are purchasing 5-year GICs that on average yield less than current inflation. They are betting that inflation will decrease over the next five years. They may be right if, as Bylo argues, gasoline has "spiked" and will revert to more normal trends. But they are also betting that something else won't spike next.

The odds are in their favour. But it is still a risky strategy.

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Re: Real Return Bonds

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Bylo Selhi wrote:Note too that yesterday's 3.7% is due mostly to a spike in gasoline prices. We won't know it it's a "one off" or "the new normal" or "the good old days" for a while yet ;)
I certainly agree wholeheartedly with the second sentence. While the first sentence is also true, things may be more complicated than they at first appear.

From Statistics Canada's The Daily for today:
Average weekly earnings of non-farm payroll employees increased 0.7% from March to $876.44 in April. Compared with April 2010, average weekly earnings were 3.5% higher.... The average number of hours worked per week, which can also contribute to growth in average weekly earnings, was unchanged from April 2010 at 32.9 hours.
Suggests to me that inflation above 3% is in danger of becoming well anchored.

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Re: Real Return Bonds

Post by brucecohen »

ghariton wrote:I've come to believe that the current inflation rate is the best predictor we have of future inflation, although I understand the attraction of using the Bank of Canada's target of 2% -- or even "core CPI" at 1.8%. You get to pick. :wink:
I use the inflation assumption that Ontario Teachers' Pension Plan uses in its annual funding projection. This projection is long-term and a critical assumption for them since most of their liabilities are fully-indexed. And it's published yearly in their annual report. Their most recent funding projection as at Dec 31, 2010 used 2.15%.
Even if future inflation for the next five years comes in at 2% or 1.8%, if one believes the Bank of Canada yields for GICs, a lot of those ladders will have negative yields.

And that goes to my point. Five-year ladders of GICs can fail as a safeguard against inflation.
That's true for someone in accumulation mode who faces no risk of having to access the money. While RRBs fully immunize against inflation risk, there are so few maturities available that the investor (saver) who unexpectedly needs money faces considerable risk. Not only is this person exposed to normal bond market risk, but IIRC RRBs are more volatile than ordinary bonds. (Also, I suspect that dealers gouge retail RRB sellers even more than ordinary bond sellers.)

My guess -- and it's only that -- is that barring a sustained, sharp inflationary surge, the weighted yield on a typical GIC ladder will be positive. That's based on 20% getting reset annually.
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Re: Real Return Bonds

Post by IdOp »

Re the general discussion, one main goal of a 5-year GIC ladder is to closely approximate the time-average of 5-year GIC yields over a longer period. Over the past number of years, those rates have I think mostly beaten inflation nicely, and anyone with such a ladder has done well that way.

It's true that if you market-value a GIC at the current lower rate, then you'll get that lower rate from here to maturity, but at the same time the implied higher market price has given you a capital gain to this point. Ultimately, the GIC earns the rate you lock in at purchase if held to maturity, and I think that's what matters most in the overall ladder approach.

As present conditions indicate, if inflation and rates rise, a GIC ladder will face challenges. Exactly how that will play out we don't know.

I think an interesting general question would be a long term comparison of upper-tier 5-year GICs with inflation. The time frame should be long enough to fairly include both rising and falling rate environments. Of course there are no guarantees of a positive real return at all times; my guess is that in the long term such a ladder would have beaten inflation. But I may easily have been misled by the 25+ year general lowering trend in rates. Does anyone know of a study along these lines?
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Re: Real Return Bonds

Post by ghariton »

Just a couple of observations.

First, to Bruce's point that a five-year GIC or bond ladder is quite liquid and that a RRB is quite illiquid. That's quite true. In fact, when you buy a ladder, you are mainly paying for liquidity, not inflation protection. The hope is that, by buying liquidity, you indirectly acquire inflation protection as well. That may or may not work out. But the important point is that, in the first instance, you are paying for liquidity.

Some liquidity is essential, and more liquidity can be good. But it`s unlikely that I need my entire portfolio to be liquid all the time, especially before I reach my 80s. So yes, a ladder can have its place if you are pursuing liquidity with part of your portfolio.

But in my case at least, I want a good chunk of my portfolio to maintain its value so that I can annuitize when I get to 75 or, more likely, 80. I have no use for liquidity for that money. By contrast, indexing for inflation becomes the primary goal. Here, I should use an inflation-indexed product. Buying liquidity is a waste -- I`m buying something I don`t need.

Second, Irving Fisher postulated a relationship between inflation and (nominal) interest rates back in the 1920s -- interest rates should rise or fall by the same amount as the change in inflation. For the next fifty years there was a flood of studies of this. The consensus, as I understand it, is that while the relationship did indeed hold in the long run, it could take 20 years or more for interest rates to adjust to inflation. In the short term (which includes 5 years), the two can diverge widely.

And we know from history that this divergence can lead to negative yields. I don`t have data going back very far on GICs of course, but Dimson et al, in Triumph of the Optimists, show that in the 1970s in Canada, the real return on`bills`was negative for the decade, and similarly for the 1950s. The same was true for the US and the UK.

So when a holder of a five-year ladder comes to renew his maturing 20%, there is no guarantee that he will get an interest rate higher than inflation. He may have to accept a negative real return because that is the best he can do (the nominal return would still be positive).

So what`s my beef. Ladders provide liquidity, and if liquidity is what you need, they`re a great idea. But many of them are sold as protection against inflation. If the latter is what you need, then a ladder may well be an inferior product.

More generally, an investor should identify his objectives very clearly and purchase instruments tailored to each. I am very suspicious of trying to hit a number of different objectives with one multi-purpose instrument.

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Re: Real Return Bonds

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ghariton wrote:More generally, an investor should identify his objectives very clearly and purchase instruments tailored to each. I am very suspicious of trying to hit a number of different objectives with one multi-purpose instrument.
I suspect few people (except perhaps the highly unsophisticated, ultra conservative, depression era folk) would limit their investments to a GIC ladder. For most, it is simply part of their portfolio.

In my case, I have about 25% of my portfolio in cash (non-registered) and a GIC ladder (RRSP). The cash is my 'sleep at night' factor from the rest of my portfolio (stocks and ETFs) AND opportunity money if I find a recreational property I cannot do without.

As another example, my 92.5 yr old mother has about 80% of her investments in a GIC ladder and 20% in an RBC dividend mutual fund. She started out at about 70% GIC ladder (30% equities) 18 years ago and that has gradually been shifted over time. She had no need to be assured of inflation protection and thus went the GIC ladder route. Granted she could have done better with perhaps a 10 year bond ladder, but she was not comfortable with 'investment accounts'. Many seniors fall into that category.
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Re: Real Return Bonds

Post by ghariton »

Not sure what happened today to RRB yields or prices, but my TD Waterhouse account suggests a significant move.

How low can the yield go?

I ask out of idle curiosity only :wink:

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Re: Real Return Bonds

Post by Shakespeare »

http://www.globeinvestor.com/servlet/Pa ... ype=fedgov shows $134.77 for the 2021 - not out of line with recent prices and 0.77% YTM.
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Re: Real Return Bonds

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Thanks for the link.
Shakespeare wrote:http://www.globeinvestor.com/servlet/Pa ... ype=fedgov shows $134.77 for the 2021 - not out of line with recent prices and 0.77% YTM.
FWIW TD Waterhose shows a price of $195.99, but that includes the inflation adjustment. And Yahoo Finance shows that XRB (which I sometimes use as a proxy) went up by 1.62% today.

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Re: Real Return Bonds

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Shakespeare wrote:http://www.globeinvestor.com/servlet/Pa ... ype=fedgov shows $134.77 for the 2021 - not out of line with recent prices and 0.77% YTM.
Shakes - when you write 0.77% YTM here, I presume this means an annual real return (above inflation) of 0.77% until 2021. Is this correct? Boy, I had not realized that safe real return expectations were that low nowdays. The question in my mind: "Is this realistic or is this an overreaction?" - realizing that this is what peering into the future is all about, nobody knows for sure.
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Re: Real Return Bonds

Post by Shakespeare »

I presume this means an annual real return (above inflation) of 0.77% until 2021. Is this correct?
Yes. The same table shows the 2021 nominal as 2.97 (and the RRB as 0.76, slightly different from my spreadsheet), which gives expected inflation of about 2.2%.
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Re: Real Return Bonds

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Shakespeare wrote:which gives expected inflation of about 2.2%.
That's the breakeven amount of inflation. It doesn't say how much of it goes to insurance against high inflation.

Chart of breakeven. Change 10 to 20 for 20 year if you'd like.
http://www.bloomberg.com/apps/quote?ticker=CDGGBE10:IND

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Re: Real Return Bonds

Post by George$ »

Shakespeare wrote:http://www.globeinvestor.com/servlet/Pa ... ype=fedgov shows $134.77 for the 2021 - not out of line with recent prices and 0.77% YTM.
Thanks Shakes.
Another question. Is there a typo or am I missing something? Your globeinvestor link shows the 2015 yield as 0.76% and the 2021 yield as 0.94%, yet you quote 2021 as 0.77% YTM.
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Re: Real Return Bonds

Post by Shakespeare »

Ignore the first four RRB quotes, which may be strips. The "real" bonds appear lower in the page.
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Re: Real Return Bonds

Post by big easy »

The 2021 yields 0.64% real as of end of day. A new low I believe. How low can they go?
The 2026: 0.70%
The 2031: 0.82%
The 2036: 0.89%

From the Bank of Canada "Real return bond - long term":
Image

Any theories as to why real yields are so low? Is it simply money looking for a port in a storm, so to speak? If all hell breaks loose, 0.8% real looks good I guess. The last time markets cratered, real yields rose though?
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Re: Real Return Bonds

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big easy wrote: Any theories as to why real yields are so low?
B of C shows average yeilds on comparable nominal government bonds to be 3.36%. That's below the most recent inflation report, which came in at 3.7%. So, on those suckers, real yields are negative.
Is it simply money looking for a port in a storm, so to speak?
I suspect that's a large part of it. Another factor is the central banks' flooding the markets with money. When there's more money than bonds, prices of bonds go up.
The last time markets cratered, real yields rose though?
Yes indeed. I was quite happy -- I completed my planned purchase of RRBs then, reaching my limit.

As far as I can tell, the culprit for the rise in real yields was the liquidity crunch. The market for RRBs is thinner than for nominal bonds, and so some were reluctant to buy RRBs. I thought that was irrational, but who am I to tell the market it is wrong?

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Re: Real Return Bonds

Post by George$ »

ghariton wrote: ...
The last time markets cratered, real yields rose though?
Yes indeed. I was quite happy -- I completed my planned purchase of RRBs then, reaching my limit.

As far as I can tell, the culprit for the rise in real yields was the liquidity crunch. The market for RRBs is thinner than for nominal bonds, and so some were reluctant to buy RRBs. I thought that was irrational, but who am I to tell the market it is wrong?

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I have some RRBs but wish I had much more.
George, do you care to tell us what % of your liquid assets are in RRBs and what your average real yield is?

I agree on the liquidity crunch causing a temporary uptick in RRB yields in 2008-09. I believe the Caisse had to dump theirs to get cash. And my employer's pension did as well to meet margin calls for other bets gone awry.
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Re: Real Return Bonds

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[quote="George$George, do you care to tell us what % of your liquid assets are in RRBs and what your average real yield is?[/quote]

RRBs are about 51% of total liquid assets, including retained earnings of my corporation. If I back out corporate retained earnings. RRBs are about 62% of the remainder. This is probably the more relevant number, as I have committed to giving away the retained earnings over the next couple of years.

I hold enough RRBs so that I can create my own inflation-indexed pension, once I retire (any year now :wink: ). That will look after necessities. The rest is for "nice-to-have".

I figure that the only contingency not covered is divorce, which tends to be very, very expensive. But while no risk is ever zero, that one is small enough for us that I can ignore it in my planning.

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Re: Real Return Bonds

Post by Shine »

I noticed in the financial page in yesterday's paper that perhaps three ETF/Funds for RRBs were at a 52 week high - what does this suggest?
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Re: Real Return Bonds

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Shine wrote:I noticed in the financial page in yesterday's paper that perhaps three ETF/Funds for RRBs were at a 52 week high - what does this suggest?
I was surprised to see how well RRB funds have done over quite an extended period. For example the TD RRB fund:

Image

Please excuse my ignorance, but I have never bought RRBs or their MFs or ETFs. How do these funds make money when underlying bonds have such low yields? By trading? Do prices volatile enough to do that?
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Re: Real Return Bonds

Post by Shakespeare »

How do these funds make money when underlying bonds have such low yields?
Because the yields were much higher when the bonds were purchased.

From today's prices the previous performance is not repeatable.
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Re: Real Return Bonds

Post by Springbok »

Shakespeare wrote:
How do these funds make money when underlying bonds have such low yields?
Because the yields were much higher when the bonds were purchased.

From today's prices the previous performance is not repeatable.
I am still puzzled. I can see that the bond prices have increased over an extended period and if sold would provide large CGs. But the funds still appear to making good returns even although RRB yields have been in the basement for a while while bond prices have presumably plateaued.

For example, TD RRB fund has 13.4% over past year.

TD Real Return Bond $10,000 invested 2010.07.13 now $11,339.99 for gain of $1,339.99 (13.4%) if distributions are reinvested.

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Re: Real Return Bonds

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Springbok wrote:I am still puzzled. I can see that the bond prices have increased over an extended period and if sold would provide large CGs. But the funds still appear to making good returns even although RRB yields have been in the basement for a while while bond prices have presumably plateaued.
I can't speak to ETFs or mutual funds of RRBs, since I hold individual bonds only. Most of these show market value about 50% higher than book value. That's partly indexation for inflation, and partly due to the fact that real yields have fallen from some 3% or 4% when I bought, to some 0.88% today according to Bank of Canada. The first phenomenon will recur in future. The second, as Shakes points out, won't. While it's conceivable that real returns could go negative, I don't think it's likely, and certainly not for an extended period of time. Not like the 1950s or 1970s...

If the ETFs, etc, are distributing the capital gains due to inflation (something I don't know), they could certainly be up in the 4% nominal yield range. But of course those gains are illusory. What matters are after-inflation returns, not nominal returns.

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Re: Real Return Bonds

Post by Shakespeare »

If the ETFs, etc, are distributing the capital gains due to inflation
They have to, since they can't know whether or not the ETF is held in a taxable account.
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Re: Real Return Bonds

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Shakespeare wrote:
If the ETFs, etc, are distributing the capital gains due to inflation
They have to, since they can't know whether or not the ETF is held in a taxable account.
Good point.

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