This is a column by regular contributor Clark.
Part I (The types of bonds) of the bond series had briefly touched upon real return bonds (RRBs), where I made an error in the calculation of my example. I posted a comment with the correction after Mike Holman of the MoneySmartsBlog pointed it out. This post will look at the bond class in detail.
Conventional bonds (both government and corporate bonds) provide fixed income and protection during stock market volatility. However, inflation is bound to eat into conventional bond returns as it would for any asset class. Conventional bonds may tout an annual yield of 5% but the real yield (after inflation takes its cut and when held to maturity) could be 2 or 3% (based on the existing rate of inflation). It could be argued that the real yield may be higher during deflation but it is a rare occurrence. Either way, there is significant uncertainty in terms of the purchasing power of that invested amount (principal + return) at the maturity of the bond. RRBs were introduced by the Government of Canada (US readers have the Treasury Inflation-Protected Securities, or TIPS in short, courtesy of the US government) to provide a hedge against inflation by earning interest on principal that is adjusted based on the Consumer Price Index (CPI).
The Indexing Process
The index ratio is used to compute the coupon or interest payment and inflation adjustment.
- Index Ratio @ current date = (Reference CPI applicable @ current date) / (Reference CPI applicable @ the date of issue of the bond)
The reference CPI applicable on the first day of any month is the CPI for the third preceding month. For example, the reference CPI for June 1 of any year will be the CPI for March from that year, which will be released in April. For any other day of the month, the reference CPI is determined by linear interpolation between the reference CPI applicable to the first day of the month in which the day in question falls and the reference CPI applicable to the first day of the month immediately following. If the CPI is not released for any month, then the Government of Canada publishes a substitute index figure that will take precedence over any CPI figure that may be released at a later date for the month in question. Generally, interest on RRBs is paid on the first day of June and December of the year.
Interest for RRBs is paid semi-annually and the inflation adjustment upon maturity of the bond.
- Interest (6-month period) = (Coupon or Interest Rate / 2) * (Principal * Inflation Adjustment at the time)
- Inflation Adjustment = (Principal * Index Ratio) – Principal
- At maturity or when sold, Final Payment = Principal + Inflation Adjustment at the time
A $10,000 RRB at 3% coupon rate with inflation at 2% would provide the following returns:
- Interest (6-month period) = (0.03/2) * (10,000*1.02) = $153.0
- If inflation rises to 3% after 1 year,
- Interest (second 6-month period) = (0.03/2) * (10,000*1.03) = $154.5
- Final Payment = 10,000 + Inflation Adjustment at maturity or when sold
- Liquidity. After the issuance of a new series of RRBs, a secondary market should be available for trade, which may or may not be at par with conventional bonds.
- Price. Since the bonds are linked to the CPI, real yield is heavily dependent on the economic developments in the country.
- Principal Loss. There is a possibility (unlikely but not impossible) that if a period of sustained deflation occurs during the holding period, then the bond owner may be left with an amount that is less than his starting investment. In such a situation, the interest payments would also be negatively affected.
- Income Variation. If the bond investor is planning to use income from RRBs for his monthly expenses, then he would be better off with a sufficient emergency cushion to ride out the fluctuations in the CPI. A significant change in the CPI over a 6-month period may decrease his monthly income and throw his budget into disarray.
RRBs are considered as ordinary income and hence, they are taxed at marginal rates when held in a non-registered account. Inflation adjustment is also taxed annually as it accrues, though the bondholder will not receive the money until maturity. So, the best place for RRBs, just like most other bonds, is registered accounts such as an RRSP or TFSA.
In the case of a Canadian non-resident bond holder, the coupon and inflation adjustment payments are exempt from the withholding tax.
Ways to buy RRBs
Do you own any RRBs? Do you think it has been (or will be) a worthwhile addition to your overall portfolio?
About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.