Canadian real return bonds have been really horrible lately.
The concept behind real return bonds is that their face value and semi-annual interest payments are inflation-adjusted. Inflation is soaring right now, so what gives?
The problem with Canadian real return bonds is that they, for the most part, mature in 10 to 20 years or more. When inflation is strong and interest rates are rising, investors hate the idea of locking in money for that length of time.
This is why the FTSE Canada Real Return Bond Index was down close to 10 per cent for the year through March 28, a gut punch for investors who thought they were holding exactly the right bonds for these inflationary times.
Roughly $700-million has been invested in real return bond exchange-traded funds in the iShares and BMO lineups. Annualized returns over the three years to Feb. 28 look rather good at 4.2 per cent on a total return basis for both the iShares Canadian Real Return Bond Index ETF XRB-T and the BMO Real Return Bond Index ETF ZRR-T.
But real return bonds have been weakened since expectations of sharper than previously expected interest rate hikes started to build earlier this year. Bond yields move in the opposite direction to bond prices, but yields on real return bond ETFs don’t look that enticing just now. For example, the after-fee yield to maturity for XRB is about 2.2 per cent.
A better performing inflation-fighter in the bond world is the U.S. version of real return bonds, which are called Treasury Inflation-Protected Securities, or TIPS. An advantage with TIPS compared with Canadian real return bonds is that there’s a selection of bonds that mature in the short and medium term rather than decades in the future.
The Mackenzie US TIPS Index ETF CAD-Hedged QTIP-NEO declined 1.4 per cent in the first two months of this year, which looks not too bad in comparison to the 4.1 per cent decline in that period for the entire Canadian bond market. Both XRB and ZRR were down a little more than 7 per cent over that period.
A less exotic option for investors who want to minimize the down side in their bond holdings as rates rise is to hold bonds that mature in five years or less. The Vanguard Canadian Short-Term Bond Index ETF VSB-T was off just 1.2 per cent for the first two months of 2022. In bondland right now, that’s success.
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