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Real return bond funds laugh at inflation

Unlike conventional bonds, when inflation rises, RRBs and portfolios made up of them rise in price and payout

Special to The Globe and Mail

Real return bonds offer inflation protection that ordinary bonds cannot provide. And for investors who seek that kind of security blanket, there are really only two fund offerings available in Canada.

The $346.2-million TD Real Return Bond Fund, established in 1994, is the older of Canada's two RRB funds. It produced a 15-per-cent return for the 12 months ended Jan. 31, highest among all Canadian bond funds for the period.

By comparison, Canadian bond funds produced an average return of 5.4 per cent and the benchmark Scotia Capital Universe Bond Total Return Index gained 7.6 per cent.

The only other RRB fund, the $41-million Genus Real Return Bond Fund directed by Genus Capital Management in Vancouver, opened for business in October, 2002. While it has no one-year return, over three months, it, like the TD fund, returned 4.9 per cent, far outpacing the average 1.4 per cent for the category.

For most investors, the TD fund is more accessible: it requires $1,000 versus $300,000 for the Genus fund, really an investment pool for high-net-worth investors.

So what makes these funds prime for inflation-protection-seeking investors? As inflation measured by the consumer price index rises, RRBs and portfolios made up of them rise in price and payout. Conventional bonds, on the other hand, tend to fall in price as their coupons become less desirable, and conventional bond funds lose value as their underlying bonds depreciate.

Trend-setting real return bonds are issued by the Bank of Canada in order to provide a way for investors to buy federal debt without the usual inflation risk that ordinary bond investors face.

The federal RRBs, which mature between 2021 and 2031, have a guaranteed basic interest rate of 4 to 4.25 per cent -- well below rates for conventional long bonds -- but add a promise that the CPI-based inflation rate will be added to the basic rate to arrive at current yield.

Because prices of RRBs have risen substantially in the face of rising inflation and increased demand, they now pay about 3.2 per cent. On top of that is the inflation adjustment. Assuming a 2.3 per cent inflation rate, the long-term rate works out to a current 5.5 per cent, says bond specialist Chris Kresic, vice-president for investments at Mackenzie Financial Corp. in Toronto.

The funds are largely stocked with the federal RRBs. Though not in the TD fund, there are also two Quebec issues with maturities of 2013 and 2026. RRBs have also been issued by Ontario's Highway 407 Authority and the PEI Strait Crossing Authority, but both are closely held and neither trades.

RRB math underlies the returns of RRB funds. As inflation rises, interest rates tend to follow as the Bank of Canada tries to increase the cost of borrowing and so reduce spending.

Investors who buy the bonds from investment dealers pay no management fees, but must pay relatively high prices compared to what institutional bond investors pay, explains Satish Rai, vice-chairman of TD Asset Management Inc. and portfolio manager of the TD RRB fund.

The combination of trading advantages and capital gains accounts for the largest part of the TD fund's return, he says.

"TD Asset Management participates in federal bond auctions and gets RRBs at the lowest price bond investors are willing to pay, a price that no individual investor can get," he says.

"In addition, the market for RRBs is very strong, driven by pension funds that need to buy relatively scarce long bonds to match obligations several decades into the future. Pension funds like RRBs since they automatically index the kitties available to pay retirees in plans that have defined benefits.

"Those two factors, along with a year-end rise in inflation, drove up the price of RRBs and so contributed to the total return of the fund."

Not every year has been so good to the fund, Mr. Rai notes. While 2002 saw the TD RRB fund capture a 13-per-cent return, it lost 1.1 per cent in 2001 as investors, shocked by the events of Sept. 11, bought up conventional government bonds and drove the TD fund's relative and absolute performance to the bottom of the class of Canada bond mutual funds.

Yet in 2000, with inflation rising, the TD fund returned 15.7 per cent, making it the top Canadian bond fund, as it was in 2002.

In spite of the recent success of the TD RRB Fund, Dan Hallett, senior analyst for mutual fund dealer Sterling Mutuals Inc. in Windsor, Ont., is restrained in his admiration.

"While the 1.65-per-cent MER of the TD RRB Fund is modest compared to the 15-per-cent total return the fund made in the last 12 months, that MER takes just about half of the fund's basic, real return," he says. "If interest rates or inflation drop drastically, as they may once issues in Iraq are resolved and the price of oil goes down, the CPI's rate of increase will fall and other bonds will outperform RRBs. Corporate bonds can pay more than RRBs and they offer better values."

Mr. Rai agrees that the suitability of RRBs and his fund depend on the investor's expectation of inflation. If deflation takes place, the RRBs will suffer.

But deflation is not widely expected and, as he points out, inflation in Canada is headed to 4 per cent on an annualized basis. With strong job growth in Canada, it does not appear that inflation over the near term will decline, he says.

As well, the RRB market that underlies any RRB fund is strong, for the federal government is projected to run surpluses for many years ahead. That means that long bonds will be redeemed faster than they are issued and will therefore be relatively scarce, forcing pension funds and life insurance companies to pay a premium for RRBs. That scenario supports RRB prices and implies a strong future for the bonds, Mr. Rai says.

Brad Bondy, manager of the Genus RRB Fund, adds an important note. Because RRBs behave unlike other bonds in the face of rising inflation, they are a unique asset class, he says. "That alone recommends them in portfolios that are designed to have the most efficient mix of assets that do not vary all together at the same time."

What's more, he says, if inflation rises over the 2.3 per cent CPI adjustment implied in the current returns of the bonds, RRBs will tend to have a premium return over expectation and RRB fund unitholders will share in the fund's resulting prosperity. By comparison, he adds, holders of conventional bonds would be losers in the face of rising inflation.

© 2007 The Globe and Mail. All rights reserved.

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