Real Return Bonds

[CalgaryGuy]

If they [iShares € Inflation Linked Bond ETF] were held in an RRSP "mark-to-market" rules, if applicable, would be irrelevant.

Provided they could be held in an RRSP, of course.

Could you explain this "mark to market rule" ?

....Somehow I feel like I'm back in school wondering if my question is really stupid, but figuring it best to know the answer either way.

[Shakespeare]

Could you explain this "mark to market rule" ?

Several years ago, a tax change was proposed that would have caused foreign ETFs to be "marked to market" once a year and tax paid on the imputed gain. A campaign was launched that successfully derailed this proposal (see Bylo's site and scroll down to "Bylo in the News" for several links).

Even if that rule had come into effect, ETFs held in RRSPs would not have had any tax due, although the foreign content rules then in effect would have been a consideration due to the changing book value.

[Feeonly.ca]

I checked out hsbcdirect. They appear let you buy shares on the ftse . Its a 55 Euro commission (min) plus a 50 euro "levee" . So minimum cost of 105 euros. pretty steep.

The extra cost is to compensate the second broker.

It can't be taboo to own the foreign shares. You can hold shares from the following exchanges in your rrsp:

It's not illegal to own foreign equity and foreign ETF's are just baskets of foreign equity. Nor is it illegal to own foreign bonds, so by extention baskets of foreign bonds should be fine.

I would get clarification from my broker but I don't see a problem.

[Bylo Selhi]

It's not illegal to own foreign equity and foreign ETF's are just baskets of foreign equity. Nor is it illegal to own foreign bonds, so by extention baskets of foreign bonds should be fine.

I would think so too, especially if they're held by a Canadian broker.

But then what to make of this?

No person resident in Canada for the purposes of the Income Tax Act (Canada) may purchase or accept a transfer of shares in the Company unless he or she is eligible to do so under applicable Canadian or provincial laws.

Presumably the xSCs are satisfied if they're held in a Canadian brokerage account. After all people hold US stocks in Canadian accounts and there's no prospectus on file with the xSCs either. So what "applicable Canadian or provincial laws" are they talking about? And why should BGI know, care about or be liable for where some iShares happen to be owned?

[Feeonly.ca]

unless he or she is eligible to do so under applicable Canadian or provincial laws

I suppose if we can buy them then it means we must be "eligible"

[ghariton]

Meanwhile, December 1 is coming up fast, and RRB 2021 yield is quoted in today's G&M at 1.52%.

Any thoughts?

Georges

[Shakespeare]

I'm going to continue to put the cash in short-term investments.

[rw1029]

I notice that 2021 RRB yields are now down to 1.52%. And to think that I stopped buying the suckers when the yields dropped to twice that level

I've been looking at these things for a while...wondering what yield you'd want to see before you considered buying them again??

[Feeonly.ca]

I've been looking at these things for a while...wondering what yield you'd want to see before you considered buying them again??

Friction aside, if you hold an investment at any given yield/price you are in effect saying that you would purchase at that price. Unless of course you already hold your full targeted allocation.

Further, if you wouldn't buy at a 1.52 real yield why would hold at that yield/price?

I struggle with this concept at times myself. While I won't add to my existing holdings, RRB's are my risk free allocation and I am loathe to sell any even at these yields.

Now if they drop to 1% I don't think I will be able to rationalize holding any longer and will likely sell the whole lot.

[Feeonly.ca]

Anyone think real yields might drop to 1% or lower as people chase performance?

http://money.canoe.ca/PersonalFinance/2 ... 16852.html

Real return bonds put in star performance while traditional bonds suffer

Mon, November 21, 2005 By WAYNE CHEVELDAYOFF

(Special) - Real return bonds have done exactly what they are supposed to do in the past few months – protect investors from inflation.

As energy prices have pushed inflation rates up in recent months, real return bond funds have continued to move higher. At the same time, traditional bond funds have suffered.

One of the largest real return bond funds in Canada, TD Real Return Bond Fund, with assets of $2.3 billion, has gained 3.5 per cent in the three months ended October 31, 2005.

Similarly, the smaller Dynamic Real Return Bond Fund (assets $64 million) has risen 5 per cent over the same three months.

By contrast, traditional bond funds have lost between 1 and 2 per cent of their value in the same three-month period.

A representative example is Trimark Canadian Bond Fund, which lost 1.3 per cent between July 31 and October 31.

The differing performance is a predictable result of the upswing in the consumer price index (CPI).

The interest payments and principal of real return bonds are linked to the CPI. Investors get a real return plus whatever the CPI gains or loses. So, an upswing in the CPI benefits the holders of real return bonds.

Not so with traditional bonds. When inflation is on the upswing, traditional bonds rarely do well, as central banks are typically raising interest rates. When interest rates go up, traditional bond prices go down.

This differing performance raises the question of what investors should do. Should you switch out of traditional bond funds to avoid further losses in the future? Should some of that money go into real return bond funds?

The answer depends on how you view the future unfolding for inflation and interest rates.

In the 1970s, the last time North America suffered such large gains in energy prices, inflation rose to close to 10 per cent and the value of traditional bonds trended lower for several years.

However, this time most economists are expecting only modest gains in inflation and bond yields and central bankers in Canada and the United States are raising short-term interest rates with the intention of preventing a 1970s-type situation from developing.

The Government of Canada 10-year bond yield, an important barometer of the bond market, has moved up to 4.15 per cent recently from a low of 3.65 per cent during the summer.

TD Economics, for example, expects the yield to rise further to 4.6 per cent by the third quarter of 2006 before trailing off to 4.4 per cent by the end of the year.

In this type of mainstream scenario, holders of traditional bond funds may see the value of their units lose a little more ground and stagnate for a while. But it won't be a 1970s disaster.

For real return bonds, much will depend on the CPI. If oil prices stabilize below their hurricane peak of US$70 per barrel, it is likely the CPI inflation rate will come down somewhat.

If so, real return bonds will likely continue to outperform traditional bonds but not by as much as they have in the recent three-month period.

Another consideration with real return bonds is that some of the gain in value has come from the decline in real yields. Long-term Government of Canada real return bonds had a 2.05 per cent real yield last February. As inflation worries picked up and investors moved into real return bonds, that real yield has declined to about 1.6 per cent recently, resulting in an extra boost to real return bond prices.

It's part of the reason why real return bond funds are up more than 11 per cent in the past year, versus only 5 per cent for the average traditional bond fund. This positive influence of declining real yields is unlikely to continue, especially if inflation is brought under control and inflation worries dissipate.

Real return bonds, held directly or via mutual funds, make the most sense in registered plans, such as RRSPs, RRIFs and RESPs. If you hold such bonds outside of registered plans, the tax treatment is quite onerous, since the CPI-linked upward adjustment of principal each year has to be reported as income even though the taxpayer doesn't receive the benefit until the bonds are sold or mature.

[ghariton]

In search of the unattainable no-risk investment, RRBs are only a step along the path. As others here and on the TWB have pointed out, they are still subject to political risk.

If one believes that there is a small but positive probability that Quebec will indeed separate over the next five or ten years, then RRBs suddenly become somewhat risky. One reaction might be to diversify into U.S. TIPS. One would accept exchange rate risk in return for reducing political risk.

Is this a good idea? What guidelines could be used to determine the percentage going to TIPS as opposed to RRBs?

Georges

[Feeonly.ca]

Hi Georges,

In search of the unattainable no-risk investment, RRBs are only a step along the path. As others here and on the TWB have pointed out, they are still subject to political risk.

For a Canadian with reasonably long horizons RRBs remain the [relative] risk free asset class.

If one believes that there is a small but positive probability that Quebec will indeed separate over the next five or ten years, then RRBs suddenly become somewhat risky.

I think there has always been a small but positive chance that Quebec will indeed separate so I don’t think RRBs become “suddenly” more risky. More like business as usual.

One reaction might be to diversify into U.S. TIPS. One would accept exchange rate risk in return for reducing political risk.

Is this a good idea? What guidelines could be used to determine the percentage going to TIPS as opposed to RRBs?

The US is also subject to Political risk [albeit not separation] so I don’t think there is any relative gain holding TIPs vs RRBs.

Currency risk is the concern and IMO foreign equity exposure is considerably more efficient than foreign bond exposure as a way to hedge currency risk.

You not only add currency risk but also considerable foreign exchange drag using TIPs. Coupon deposits and reinvestment from within an RSP/RRIF account [the logical place to hold TIPs] is such that the real yield would be diminished by one third from the FX transaction costs alone.

My recommendation is hedge currency risk with foreign equities not foreign bonds.

Now if you were anticipating a specific but long into the future USD dollar purchase then the TIPs may well be the appropriate savings vehicle. I still don't like the FX costs so I would attempt to purchase iStrip TIPs (stripped TIPs by Barclays) instead of actual TIP's or a TIPs ETF.

[Brix]

My recommendation is hedge currency risk with foreign equities not foreign bonds.

I'm curious about the logic behind this recommendation. Is it simply that foreign equity instruments are more widely available and (therefore) less expensive to acquire? What if the portfolio is, say, 70% bonds?

[ghariton]

I think that Quebec separatism has become much more likely, given the events of the past year or so, although it is still not a major risk. Nevertheless, "doing something" to mitigate the risk may be a good idea. It depends on the cost.

Following on feeonly.ca's post, I think he is right that the problem is partly a currency one. Quebec separation would impact the Canadian dollar, and probably lead to a major devaluation. That can be hedged against, directly. Anyone have any ideas on the most efficient way, and how much it would cost?

But there is another risk -- default risk. Would The Rest of Canada honour current debts of the federal government? Or would they honour only 75% of them? Or no part of them? Indeed, would there be a Rest of Canada to honour any federal government bonds? How do we hedge against this, short of moving money into the securities of another country (or of companies doing business elsewhere)?

Georges

[Feeonly.ca]

Georges:

But there is another risk -- default risk. Would The Rest of Canada honour current debts of the federal government? Or would they honour only 75% of them? Or no part of them? Indeed, would there be a Rest of Canada to honour any federal government bonds? How do we hedge against this, short of moving money into the securities of another country (or of companies doing business elsewhere)?

The Govt of Canada [the issuer] would honour 100% the obligation [a la printing press]. The process they use to get an independent Quebec to pay their share into the coffers would be a "separate" issue.




Brix:

I'm curious about the logic behind this recommendation. Is it simply that foreign equity instruments are more widely available and (therefore) less expensive to acquire? What if the portfolio is, say, 70% bonds?

The logic is to use the most efficient tool for the job. There are less FX costs associated with holding foreign equities.

Of course I intended this is as a general rule. While I think the principle could still apply to a 70% bond portfolio I hope I don't need to preface all my remarks with "this may or may not be appropriate in every situation".

[_PK_]

Regardless of the odds of seperation, it is not entirely clear to me what the effect would be on the C$. As is often pointed out, Quebec is subsidized and their Provincial debt situation is, I think, relatively worse then many of the other Provinces.

Since I'm not even sure of the directional effect on the C$ if separation happened, I don't know why I wouldn't just trust how the market has priced my diversified portfolio.

BTW, if I was to speculate on the future relative price of the US/Can $s, I wouldn't bet on the US -- their fiscal situation is miserable.

[ghariton]

Regardless of the odds of seperation, it is not entirely clear to me what the effect would be on the C$. As is often pointed out, Quebec is subsidized and their Provincial debt situation is, I think, relatively worse then many of the other Provinces.

Maybe so. But I seem to remember that the Canadian dollar took a hit both in 1980 and 1995, especially when the "Yes" side gained in the polls.

While I'm sure that TROC would be better off in terms of equalization payments, there is a significant risk of trade disruption and major reorganization costs, especially if separation is unilateral, as it probably would be. Everyone, except perhaps Alberta, would be much worse off.

And it's not clear to me that the individual provinces are legally bound to honour debts of the federal government. Once that government is gone, we would have to rely on the political goodwill of the provinces, it seems to me.

You're probably right in saying that all this is already priced into the market. But I still think it has become a non-trivial risk.

Georges

[Shakespeare]

if separation is unilateral, as it probably would be.

Unilateral separation might go unrecognized. IIRC one of the Australian states declared independence at one point. Everybody, including the Canberra government, ignored it.

[Bylo Selhi]

BTW, if I was to speculate on the future relative price of the US/Can $s, I wouldn't bet on the US -- their fiscal situation is miserable.

Which is one reason for my interest in this ETF, symbol IBCI in London. (The other is that I'd rather spend retirement time in Europe than in the US.)

BTW TD WH is sending me more info but so far they tell me that they can do trades on all major European exchanges. Brokerage fees aren't pretty though, ranging from $150 on $5k to $500 on $100k plus 1/2% tax, plus FX vig to go from CA$ to Sterling.

[Norbert Schlenker]

An RRB ETF is coming.

[Shakespeare]

As well as dividend (XDV) and income trust (XTR) funds.

However, the MER's are too high: 0.35% for XRB, 0.50% for XDV, 0.55% for XTR.

[Norbert Schlenker]

Given the MERs on alternatives, XRB would be quite a bargain. Of course it's better to just buy and hold the RRB directly. It's still a damned sight better than the open-ended funds in the market now.

[Bylo Selhi]

it's better to just buy and hold the RRB directly. It's still a damned sight better than the open-ended funds in the market now.

Also XRB tracks Scotia Capital Real Return Bond Index which may (it's not clear from the linked document) provide exposure to provincial and corporate RRBs. If so, that may offset the MER. Anyone know the constituents of SCRRBI and their weightings?

[Shakespeare]

The TD RRB Fund currently has inflation-indexed and unindexed bonds, and includes TIPS. The MER is too high but the holdings are interesting:

Top Holdings as of Sep 30, 2005
Gov't of Canada 4%, DEC/01/31 21.02%
Gov't of Canada 4.25%, DEC/01/26 17.00%
Gov't of Canada 3%, DEC/01/36 13.63%
Gov't of Canada 4.25%, DEC/01/21 11.49%
Province of Ontario 2%, DEC/01/36 5.79%
Province of Quebec 4.5%, DEC/01/21 5.11%
Province of Quebec 3.3%, DEC/01/13 4.09%
UNITED STATES TREASURY INFL 01.63 150115 2.83%
UNITED STATES TREASURY INFL 02.38 250115 2.82%
UNITED STATES TREASURY INFL 02.00 140115 2.71%
Gov't of Canada 3%, JUN/01/07 2.31%
UNITED STATES TREASURY INFL 03.63 280415 2.01%
Gov't of Canada 4.5%, SEP/01/07 1.57%
Province of Quebec 4.5%, DEC/01/26 1.54%
Gov't of Canada 4.25%, SEP/01/08 1.44%

[Bylo Selhi]

iShares € Inflation Linked Bond ETF symbol IBCI in London.

TD WH just confirmed that this is RRSP-eligible.