This seems to be a hot topic recently, with recent negative returns being explained in various ways:
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.
Note that the chart at the top of this article shows the Price Return, not the Total Return, an editorial decision I consider dubious.
But with respect to the quoted text, let’s just say that I’m not entirely satisfied with that explanation, so after I received a query …:
Why is it that RRBs are going down in value right now even though the last few months have seen unexpected inflation (unexpected at the time of the bond’s purchase, i.e. not priced into long term bond yields at the time). I thought that this was the environment that RRBs were supposed to do well in?
… I resolved to provide a more useful answer:
The situation with RRBs is interesting, but it isn’t as bad as you might think. We can compare – cautiously! – the funds:
ZRR : LINK
ZFL : LINKThe former is a Real Return Bond fund (based on the universe of RRBs) and the latter a long-term federal bond fund (based on the long-term Canada index). It would be nice if there was a fund restricted to long-term RRBs, but there isn’t (as far as I know) and ZRR has an average term of 17.87 years (compared to ZFL’s 25.83) so the comparison, while not perfect, isn’t too bad.
ZFL has a 1-year return of -6.97%, compared to -0.95% for ZRR, which is a very dramatic difference! This is because the inflation-adjusted principal value of RRBs has increased dramatically over the past year, due to inflation experienced, despite the lag of three months in incorporating new data.
The question of why ZRR has a negative return at all is interesting. If we look at yield statistics from the Bank of Canada ( LINK ), we see that the yield on Long-term (nominal) Canadas is 2.61%, while the Real Return on long-term RRBs is 0.74%. This implies that the “Break-Even Inflation Rate” (BEIR) is only about 1.9%, which may be considered surprising.
This is the average annual inflation rate over the entire remaining term of the bonds that will result in the two types of bond having the same total return. If the actual inflation rate over the period is higher, RRBs will have done better; if lower, then nominals will have outperformed. So one can choose which type of bond to buy based on one’s prediction of Canadian inflation over the long-term.
The fact that the BEIR is still actually below the 2% midpoint of the BoC inflation target implies that the market believes the current bout of inflation is temporary. If the market believed that future inflation was going to average, say, 4% over the long term, then the current 0.74% real rate would imply a yield of 4.74% on comparable nominals, more than 2% over current levels, which would be a price change of somewhere near -30% for the nominals, a crushing (nominal) bond market crash.
So part of the answer to your question is that inflation expectations are ‘well-anchored’; people believe that in the relatively near future things will get back to normal, whatever that means.
The other part of the answer is that real yields have been climbing for the past year (see the chart at the top of LINK ; the blue line is the long-term real yield. COVID took the long-term real yield negative, a ridiculous and completely unsustainable state of affairs; real yields have gone from -0.25% around the end of 2020 to +0.74% today; a change of about 1% in yield that implies a price change of around -15% in price.
In other words, bonds in general are doing poorly today because they did so well in the early stages of the pandemic and became – as we can tell with hindsight – grossly overpriced.
How high can real yields go? The current level of +0.74% for a long bond looks awfully skimpy to me. It’s within its range of the past 10 years, but the past 10 years have been affected by aftershocks from the Credit Crunch of 2007-09, as well as what some people think are permanent structural changes due to the aging of baby boomers, fewer kids and reduced needs for capital investment in new factories to make things. You can play with the slider on the graph at LINK and extend the chart’s origin to 2000, when real yields were in excess of 3% and the BEIR was about 2.5%. Pay yer money and take yer chances!
Inflation in TSE market quotes, via IBKR
Effective May 1, 2022, the monthly market data fee for the Toronto Stock Exchange Top of Book professional subscription will increase to CAD 37.50/month.