Real Return Bonds

[Shakespeare]

Anything under $5,000...$50,000... $100,000?

Depending on your broker, you will need to buy at least $5K face. But $10K is better and you will get a price break at $25K. The face value has to be multiplied by the index ratio and then the price to get the amount you finally pay. The 2036 bonds will be the cheapest in current $. The 2021 bonds will cost around $170 for $100 face and are the most expensive.

You should get an RRB with a maturity that approximately coincides with your life expectancy.

t seems XRB's div includes a CPI component - how does one calculate it?

That isn't clear yet.

Added: the June distribution probably represents the running yield (cash-on-cash) less the MER. That suggests the CPI portion will be distributed in December. The market value of most of the underlying bonds is above par so the unit value will drop as the bonds approach maturity, so the overall real yield will be less than the running yield.

[MaxFax]

1.) Don't buy the RRBonds directly. The transaction costs to buy and sell them is about 3% each way.... about a year's interest.

2.) The government gives you the most recent days' yield at the bottom of the page:
http://www.bankofcanada.ca/en/rates/bonds.html
I know there are different issues of RRBonds so I assume this is some kind of average.

3.)The history of yields is shown on the previously referenced page:
http://members.shaw.ca/RetailInvestor/RRBond.xls

4.) The yield you will realize personally is the total of: a)the yield in 2., plus b) the current rate of inflation, less c) the MER of the fund.

[Shakespeare]

Don't buy the RRBonds directly. The transaction costs to buy and sell them is about 3% each way.... about a year's interest.

No, it's about half that. Applying all that cost to the purchaser is also arguable; conventionally half is. In any case, even amortizing 1.5% over 15 years is around 0.1% - far less than the XRB MER.

[Norbert Schlenker]

2.) The government gives you the most recent days' yield at the bottom of the page:
http://www.bankofcanada.ca/en/rates/bonds.html
I know there are different issues of RRBonds so I assume this is some kind of average.

Actually, that's the yield on the benchmark bond, which these days is the 2031 maturity. For an average, you can use Scotia's index page, usually available by midnight Eastern time. For individual issues, search the G&M website for "canadian bonds" and look at the very bottom of the second page of any story under the title "Canadian Bonds / CBID". Note that all of these rates are wholesale, so you are not going to get close to the published yields unless you're trading a million face.

3.)The history of yields is shown on the previously referenced page:
http://members.shaw.ca/RetailInvestor/RRBond.xls

Nice work, MaxFax. I take it that goes back only to 1996 because that is what is on the Bank of Canada website now. I'm pretty sure I mined the BoC site back in 2004 and got similar data back to the start of 1993, but I'll have to look for it. I consider it public domain information even if BoC has expired it. PM an email address to me if you're interested in adding it on and I'll try to dig it up.

[Cheryl]

Thanks for all the helpful replies. I've never bought bonds directly before, so am a tad apprehensive but will call BMOIL and enquire just to get familiar with the process etc. Thanks again, C.

[Bylo Selhi]

I've never bought bonds directly before, so am a tad apprehensive

This may help to put you at ease: Buying and selling RRBs

[Cheryl]

Yes, thanks Bylo! Thank goodness for that guide of yours! I'd made a mental note to print that page and refer to it during the call - esp the 'How do I buy an RRB?' part. I wish there was something for regular bonds too - tho I'm guessing buying them is more straightforward than RRBs. There should be stuff online elsewhere and I should look, but I'm kind of addicted to this forum (even tho I don't post much), so spend most of my time here.

[milo]

1.) Don't buy the RRBonds directly. The transaction costs to buy and sell them is about 3% each way.... about a year's interest.

How can one calculate the transaction cost?

[Shakespeare]

How can one calculate the transaction cost?

The easiest way is to check the bid-ask spread online, for those who have access to online quotes.

A more difficult way that works over time is to buy RRBs in several tranches. Comparing the purchase price to the previous day's valuation will gradually allow the spread to be determined as valuation changes average out. These comparisons were done several years ago on a predecessor forum, and gave the spread of about 1.5% that I mentioned.

Someone with online bid-ask access may be able to give a current spread.

Conventionally, 1/2 the spread is assigned to the purchaser. XRB may be cheaper for short holding periods, but for holding to maturity the direct bond purchase will be cheaper.

[Feeonly.ca]

How can one calculate the transaction cost?

It's quite straightforward:

1. Request the "Ask Price" on a particular bond.
2. Request the "Bid-Price" on the same bond (as if you were to sell it back to the broker on the next call).

The difference between the two Prices is the "spread" or approximate total expected transaction cost, if you intend to sell before maturity.

If you hold the bond to maturity your total expected transaction cost is approximately one-half of that spread. This is because you won't have the cost of the Sell transaction at the bid price.

[northbeach]

On July 12 ghariton wrote:

Yields on July 11, as shown in today's Globe and Mail, range from 1.78% to 1.83%.

I note that (1) the yield curve has been flat for a long time -- is any meaning to be attached to that? (2) the uptick in yields that I expected hasn't happened yet -- and thanks to Dodge's recent anouncement, is now unlikely.

Time for me to buy (only six weeks off my plan).

Is it a good time to buy RRB's.

[ghariton]

Is it a good time to buy RRB's.

Today's Globe & Mail show yields of 1.63% to 1.70%. So July 11 was a good time to buy, at least in the short term.

I don't know anyone who can predict interest rates, real or nominal. If there are such people, they are keeping the nformation to themselves and probably becoming super-rich.

On the other hand, recent experience suggests that real returns, and hence RRB prices, don't move very quickly. So risk is less than with nominal bonds. That suggests to me that it is not useful to try to time the purchase of RRBs. Buy when you have the money ready and RRBs make sense in your portfolio.

But others on this forum have different views, and will not buy below a target real return (2 % seems a popular floor).

Georges

[Shakespeare]

But others on this forum have different views, and will not buy below a target real return (2 % seems a popular floor)

Many of us already have a 'base' RRB allocation, and are keeping additional funds in short-term bonds for the moment. Or buying TIPS.

[milo]

But others on this forum have different views, and will not buy below a target real return (2 % seems a popular floor)

Many of us already have a 'base' RRB allocation, and are keeping additional funds in short-term bonds for the moment. Or buying TIPS.

For some of us newbies with no RRB allocation,
would you recommend this be as good a time as any to buying RRB?

I called the TDW bond desk last week and got a quote=
4% RRB maturity dec 1, 2031
cost $30000
face $16000
nominal price 176.10
real price 146.70
real yield 1.71
index 1.20038

Lets say I buy the above spending $30000.
Am I correct to say these?=
Interest payment 2 times a year. each payment= $16000 x 4% x index / 2 = $384
At maturity, in dec 1, 2031. I will get back = $16000 x index <====is this correct???

[Shakespeare]

spending $30000.

176.10*16000/100, + accrued interest (which you will get back in December.) 28176+accrued interest.

each payment= $16000 x 4% x index / 2 = $384

That's right now. The nominal amount will change as the index changes.

At maturity, in dec 1, 2031. I will get back = $16000 x index <====is this correct???

Yes.

[milo]

thanks shakes, what about this question?

For some of us newbies with no RRB allocation,
would you recommend this be as good a time as any to buying RRB?

[Shakespeare]

what about this question?

That's something you have to answer for yourself: it depends mainly on how much you want to pay for the security of inflation protection. Nobody can tell you whether yields will improve from this point.

[Norbert Schlenker]

Time to throw a few sparks around.

I get asked questions like

would you recommend this be as good a time as any to buying RRB?

by clients all the time. My usual answer is, "Don't time the market. Neither of us knows any better than the market what the right level is for real rates (or equity prices or anything else), so you buy them to fill out your asset mix." Most clients are pretty good about following that advice.

However, there are a few extremely observant people who read - and occasionally post - on this forum and they know darn well that I have been out of RRBs for some time and still am in my own account. So they ask even harder questions like

If RRBs are so good, why don't you own any?

That's a great question, the sort of question that a teacher - which is what I consider myself when it comes to clients - loves to get from a student, even if it provokes some blushing.

Let me cut and paste from a couple of emails that I sent in response to questions like that, one late last year, one early this year.

I believe that there is still no real value in RRBs. IMO 1.5% on the 2021s is, in the long run, a pretty poor rate of return. Of course it's risk free and maybe, just maybe, real returns in the markets of developed countries will not match the 19th and 20th century experiences ever again. I find that a possibility but, as you know, I'm not betting that way myself.

As another reference to try to figure whether things are expensive or cheap, I also compare RRB rates to TIPS rates, which are all hovering around 2% now. The US has an economy with much more serious financial problems than we have - a big federal deficit, a huge trade deficit - that should result in higher inflation there than in Canada. In that case, there should be a much bigger demand for TIPS in the US than for RRBs in Canada, i.e. real yields should be lower in the US. That they're higher causes me to believe that something else is going on in Canada, the simplest explanation being performance chasing. That always goes wrong in the end.

I am still out of RRBs myself. You can't take that as any indication of wisdom. I sold the damn things at a ~2% yield. Given yields today, that left a lot of money on the table. I don't have to feel too bad because I bought regular bonds with the proceeds but I’m still about 5% behind where I would have been on that piece of the portfolio, around 1/2% overall. That stings but it's hardly fatal.

I have no idea what the future holds. I'm still out for what I think are three good reasons.

1. I think that 1.5% real is just too low long term to compete with other securities. One of these days, stocks are going to take off, really take off, on a multi-year run. Three or four straight years of high returns on equities attracts new money and that has to come from somewhere, like bonds with low yields.

2. RRBs have done really well lately because real yields declined. While there should be a fixed relationship between real and nominal yields - inflation being the difference - I am unconvinced that there isn't a tie between the two that has reduced RRB yields just because nominal yields also fell. The nominal yield curve is starting to rise. Some of that has to do with signs of coming inflation but suppose that the tie I suspect really exists. Then rising nominal yields will drag up real yields as well. I can't prove any of this but there is some academic grounding for the idea. It comes from a paper that studied TIPS yields (i.e. US data) and concluded that such a residual tie could be explained by assuming that a proportion of marginal buyers were taxable. The gist of the argument is that falling nominal yields are highly correlated with falling inflation, and falling inflation means that the index adjustment is less painful for a taxable TIPS holder, thus providing an incentive for taxable holders to add TIPS when they would be otherwise uneconomic. If that's true - and there is some statistical evidence - then the opposite is true as well; i.e. rising nominal yields mean rising inflation mean painful index adjustments for taxable holders mean larger than expected rises in real yields.

3. One always has to beware of fads in investments. People will buy whatever shows as already having done well in the paper. RRB funds are top of category when it comes to bond funds, so that's what people buy. They don't understand the tax problem they're in for if they're not buying in an RRSP, they don't really understand what the hell an RRB is, all they can see is that the funds are at the top of every list, so gimme some of that. 10% a year, year after year, is very seductive, especially in bonds. When that stops - it has to and this particular statement isn't an opinion but a mathematical fact - the people who bought just because it was doing well are going to sell just because it is doing poorly. TD couldn't get people to buy their RRB fund when real yields were at 5% or 4% but people are pouring money in now that yields are 1.5%. If real yields do start rising, then the "10% sure thing" starts looking like a loser, the money starts pouring out just as fast, and the funds have to sell out of their portfolio, thus raising real yields more, reducing total returns more, causing more money to flow out, etc.

So there you have it: three perfectly good reasons why current market rates are unjustifiable. Of course the market tells me just about every day that I'm an idiot, so there's no reason that you should pay any attention at all to what I just wrote.

All the numbers have changed since those two letters were written but the reasoning remains unchanged. I own TIPS again but not RRBs.

This is market timing, pure and simple, and I cannot advise anyone else to do anything so foolish. The right thing is to set your asset mix, buy appropriate securities, and go to sleep for a year. But if you want plausible sounding reasons not to do so in the case of RRBs, feel free to borrow some of the rationalization above.

Better still, convince me that my arguments are all wet, so that I do the right thing as well. I could use some sleep.

[scomac]

Better still, convince me that my arguments are all wet, so that I do the right thing as well. I could use some sleep.

I'm not going to do that, Norbert. I agree with your rationale completely and feel that you have very eloquently stated those reasons in your second quote.

Like you, I don't own any RRBs either, even though I would like to include some in our portfolios. You may wish to call this market timing, but I prefer to view it as a simple value proposition. I can buy inflation protection with the prudent use of dividend growth stocks. At current real yields, RRBs simply don't offer us any particular advantage over a nominal ladder.

[ghariton]

This is market timing, pure and simple, and I cannot advise anyone else to do anything so foolish.

Cheer up, Norbert, you're only human, after all.

Triumph of the Optimists, by Dimson et al, show real return on bonds in the U.S. averaging 1.6% from 1900 to 2000, and 1.8% from 1950 to 2000 (a more relevant period). For Canada, the corresponding numbers are 1.8% and 2.5%. For Australia, they are 1.1% and 0.1%. In all three countries, many decades have a negative average real return.

So I don't see anything unusual about 1.5% or the current 1.7% in Canada. But of course I don't believe I can predict future returns.

More importantly, I fully expect the nominal yield on a RRB to be lower than the nominal yield on a regular bond. After all, I have defeased the risk of unexpected inflation. And I am willing to pay for that risk reduction -- at least a half percent per year, and maybe more.

Perhaps I am unduly bothered by the risk of unexpectted inflation. But it certainly exists, as Dimson's numbers show. I am buying what, to me, seems like cheap insurance. Unfortunately, many holders of RRBs don't even realize that this is one of the main benefits. Heck, some don't even know what inflation is.

AS to your three points. If you really expect a boom, with stocks about to take off, surely you should be puttiung your money in stocks, not nominal bonds. It seems to me that one should have a "bar-bell" portfolio, with RRBs for safety and QQQs for appreciation. (All right, some SPY, etc, just in case.)

Your second point postulates that rising nominal rates will lead to some rise in real rates as well. That is certainly plausible in the very short run -- nominal interest rates are more volatile than inflation. But I wonder if it remains true for periods of a year or more. Over such periods, I would expect that some investors, at least, will be scared by unexpected inflation and will seek out RRBs, putting upward pressure on prices. Just :speculation, of course.

Yopur third point is that RRBs are a fad investment and that fads should generally be avoided. An interesting contrarian position, and one that I have some sympathy with. But I don't really care why others buy the things. I believe (perhaps wrongly) that I understand them, and that I am holding them for good reasons. As to the possibility that fads end, and that there will be a selling spree, yes, of course, that is possible. But RRBs are not very volatile in ordinary times, and so the trigger for the sell-off is less likely than for, say, the tech or the energy sector of the stock market. And since I am holding for the long term, it does not bother me anyways.

Your implicit fourth point is that TIPS look more attractive than RRBs, so perhaps one should concentrate on TIPS. I agree that TIPS are a wise diversification from RRBs, and I do hold some. But the majority of my holdings is in RRBs. You yourself gave me the reason some years ago -- avoid foreign exchange risk. After all, I plan to live out my remaining years in Canada, spending Canadian dollars. Why should I incur the risk of adverse movements in FX rates? And all for 0.5% a year?

Georges

[kcowan]

As a contrarian by nature, I ask myself why would the vendors have come up with RRBs? Do they believe they can make more/bigger spreads by offering them? If so then they cannot be good for me.

[jiHymas]

As a contrarian by nature, I ask myself why would the vendors have come up with RRBs? Do they believe they can make more/bigger spreads by offering them? If so then they cannot be good for me.

You can analyze nominal rates as:
Nominal Rate = Real Rate + Inflation Expectations + Inflation Risk Premium

By issuing real-return bonds, issuers are keeping the Inflation Risk Premium for themselves, rather than paying it to investors.

[ghariton]

As a contrarian by nature, I ask myself why would the vendors have come up with RRBs? Do they believe they can make more/bigger spreads by offering them? If so then they cannot be good for me.

Same reasoning can be applied to any security. If someone wants to sell it, why would I buy it? Might as well put my money in a wool sock.

As Mr. Hymas says above, a large function of security design is to achieve an optimal allocation of risk between issuer and purchaser. Some people or institutions can diversify risks better than can others. As well, proper design of securities can be shown to reduce agency problems, i.e. give proper incentives to both parties to work for the common good.

In the case of RRBs, I like the idea that government bears the risk of unexpected inflation. Maybe they will be extra careful (once the volume of outstanding RRBs becomes big enough).

Anyway, as has been said elsewhere, RRBs are bought not sold. I do remember aparticipating in a letter-writing campaign urging their creation, back when John Turner was Finance minister. Think of the government as being responsive -- with a very long delay -- to demands of investors.

Georges

[kcowan]

As a contrarian by nature, I ask myself why would the vendors have come up with RRBs? Do they believe they can make more/bigger spreads by offering them? If so then they cannot be good for me.

Same reasoning can be applied to any security. If someone wants to sell it, why would I buy it? Might as well put my money in a wool sock.

I would rather make my bets against another investor that wants to sell a stock to me than the government or institution. There are always day-traders, and asset allocators who are selling on formula.

I don't trust the sock. It has a tendency to burn a hole. As in, wow where did all that cash go?

As Mr. Hymas says above, a large function of security design is to achieve an optimal allocation of risk between issuer and purchaser. Some people or institutions can diversify risks better than can others. As well, proper design of securities can be shown to reduce agency problems, i.e. give proper incentives to both parties to work for the common good.

Well if the government is motivated to keep inflation in check, that has to be good for everyone (well almost everyone).

[Norbert Schlenker]

If you really expect a boom, with stocks about to take off, surely you should be puttiung your money in stocks, not nominal bonds. It seems to me that one should have a "bar-bell" portfolio, with RRBs for safety and QQQs for appreciation. (All right, some SPY, etc, just in case.)

(Go for the Bodie solution: indexed bonds for the base and LEAPs for gravy. ) My expectations are irrelevant. It's just an observation that, at a time when a competing asset class has done very well for a period of time, there's a bandwagon effect that pulls money out of an underperforming asset class. I think it's no coincidence that RRB yields were 4-5% when returns on equities were consistently 10%+.

Your second point postulates that rising nominal rates will lead to some rise in real rates as well. That is certainly plausible in the very short run -- nominal interest rates are more volatile than inflation. But I wonder if it remains true for periods of a year or more. Over such periods, I would expect that some investors, at least, will be scared by unexpected inflation and will seek out RRBs, putting upward pressure on prices. Just :speculation, of course.

Plausible to be sure. But the converse argument should hold then too. As investors become used to falling inflation or a consistent low rate of inflation, they should shun RRBs, putting downward pressure on prices. We have a 15 year time series on RRB prices now, a large part of which had falling or low inflation, but real rates fell, not rose. So the facially plausible argument didn't work in real life. We need a different theory.

Yopur third point is that RRBs are a fad investment and that fads should generally be avoided. An interesting contrarian position, and one that I have some sympathy with. But I don't really care why others buy the things. I believe (perhaps wrongly) that I understand them, and that I am holding them for good reasons. As to the possibility that fads end, and that there will be a selling spree, yes, of course, that is possible. But RRBs are not very volatile in ordinary times, and so the trigger for the sell-off is less likely than for, say, the tech or the energy sector of the stock market. And since I am holding for the long term, it does not bother me anyways.

If you're happy with 1.7%, that's a good attitude to have. I think 1.7% is so low that there are too many other asset classes that are more attractive. TIPS get me 0.8% more, albeit with FX risk. Nominal bonds will, I believe, do better than that in future. The favourite of many posters here, equities with a decent dividend and good prospects of raising that dividend at or in excess of inflation, will do better.

Regarding volatility, I think you underestimate the danger. RRBs were crushed in 1994 - along with nominal bonds, I admit - when real yields rose by about 1%. You can't think it's impossible for real yields to rise 1% from current levels, since you bought most of the RRBs you own today within the past five years at yields more than 1% higher than today's. If yields rose like that, I trust you would be able to square things away with the thought that you had defeased a liability and it had stayed defeased. Many investors in similar circumstances would look at the value of their RRSP - where a fortuitously timed acquisition of, say, TD Real Return Bond would have returned better than 10% a year for four years running (with "no" risk because the portfolio is indexed government bonds) - and wonder how their expectations of a considerably more posh retirement could turn to ashes in short order.

TD Real Return strikes me as a terrific example of performance chasing. Just prior to its amazing four year run of double digit positive returns, there was a whole $90 million in the fund. Now there's $2.5 billion. I suppose that could be because everyone is consciously defeasing their retirement liabilities with a minimum risk instrument like you, George, but I doubt it. I think they looked at the fat return every year for four years running and thought, "I gotta get me some of that!"

At the end of 2006, the year's return on that fund could easily be negative. (I would guess an average 1.8% yield would accomplish that.) One more year like that, say 2.1% or higher yields on RRBs at the end of 2007, and I will bet that TD's fund goes from $2.5 billion in assets to under a billion. That's a big deal because TD's fund is not a small player: there are only about $20 billion in RRBs outstanding across all four maturities. Once the ball starts rolling - once people realize that 10% or more every year isn't going to happen - then it's downhill. The bottom of that hill isn't likely to be $90 million, but it will be a lot less than $2.5 billion.