Income investors who think that inflation will run higher than the 2.7 per cent currently implicit in Real Return Bond yields will be interested in going long these bonds.
The Stock: iShares DEX Real Return Bond Index Fund (XRB) Recent price: $22.55
Trend: Inflation expectations are eating away at bond prices and forcing investors to look for ways to protect income flows in a bearish credit market environment. Worries about inflation - which clocked in at an annual rate of 3.3 per cent in March - and rising interest rates tend to drive bond prices down as investors demand bigger discounts to secure a better yield on their investments.
Although the Government of Canada’s long-term benchmark bond yield is currently 3.7 per cent after pulling back from recent year-to-date highs, yields - which move inversely to bond prices - have been trending north since the end of the third quarter last year. Bond exchange traded funds trading on the TSX did advance last week, but on very light trading volume – a tepid move that underscores the bearish bond trends in place across a spectrum of maturities.
There are investment instruments designed to protect income flows from inflation and interest rate changes, including floating rate bonds represented in the Horizons AlphaPro Floating Rate Bond Fund (HFR). Another inflation-protected security is the Real Return Bond (RRB), which adjusts interest payments to the realized rate of inflation and guarantees the real value of coupon payments and principal based on periodic adjustments to the reported CPI inflation rate. Issued by the Government of Canada, RRBs are similar to Treasury Inflation Protected Securities (known as TIPS) issued by the U.S. Treasury. In traditional theory the difference between the yields on nominal bonds and these inflation-protected securities reveals the market’s inflation expectations. Income investors who think that inflation will run higher than the 2.7 per cent currently implicit in Real Return Bond yields will be interested in going long these bonds.
The Trade: The iShares DEX Real Return Bond Index Fund, like the BMO Real Return Bond Fund (ZRR), is basket of real return bonds and offers an attractive way for investors to gain diversified exposure to these protected returns. This bond ETF has been in a Stock Trends Bullish category since May of 2009 and is currently outperforming Canadian equities, as represented by the benchmark performance of the S&P/TSX Composite, over the past three months. The fund is trading at a 52-week high and is positioned to carry its relative price performance forward.
The average 2.5 per cent difference in yields between nominal and real return bonds recorded to date this year – now elevated to 2.7 per cent - is more in line with the average 2011 inflation rate predicted by surveyed economists and more moderate inflation expectations of the Bank of Canada than March’s 3.3 per cent headline inflation. However, a recent survey of Canadian corporate leaders points to business inflation expectations closer to 3 per cent and higher, the current inflation reading extending enough this quarter to accelerate interest rate hikes. Given the rising trend in expectations showing in RRB prices, this could be another sweet spot for this bullish trending fund.
The Upside: Staying on the right side of inflation is currently a major broad market focus, but is always a critical objective for fixed income investors. In periods of rising inflation RRBs will provide the purchasing power protection they are designed for, and this fund should continue to market outperform and make new highs through the summer.
The Downside: Inflation protected bonds lose their advantage over conventional bonds when inflation moves below expectations, although this remains a bearish environment for nominal bonds.
Published in Stock Trends
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