Real Return Bonds

[ockham]

Ishares shows XRB's YTM (as of Aug 24/10) as 1.30%.

[ghariton]

Looks as if there's quite a bit of volatility for a bond. Using XRB as a proxy -- a doubtful manoeuvre I know -- Wednesday had a swing of 1.18% intraday, between $21.08 and $21.33. That's an awful lot for real return bonds.

But then I find that XRB has strange moves for no reason I can discern. Often there's a sharp rise or drop near closing, only to be reversed the next morning. None of this fluctuation shows up in the Bank of Canada numbers, which tend to be pretty flat with a very slight trend down in yield.

George

[ghariton]

Bank of Canada reports an average yield of 1.33% for yesterday.

Sorta like watching a limbo dancer.

George

[bones1]

Yeah, I want to buy some more real-return bonds, but I'm having a hard time justifying the purchase at these low yields. Why are the real yields so low? I can understand the low yields in nominal bonds, but what's driving the price for RRBs? Are pension funds driving the prices up? I'd really like to buy them with a yield closer to 2%.

[squid]

Why are the real yields so low? I can understand the low yields in nominal bonds, but what's driving the price for RRBs?

Isn't a RRB priced at nominal less expected inflation? At ~ 2.1% less than nominal, the market is pricing in inflation at 2.1% right? That doesn't seem too unreasonable for a long term rate of inflation, if not a little low.

[ghariton]

I'd really like to buy them with a yield closer to 2%.

Last time I bought any was at the end of 2008, when the real yield rose to 2.4%, as I recall. Perhaps similar bargains will be available during the next financial crisis.

The gap between the yields on nominal and real bonds, currently about 2.1% as squid points out, covers (a) expected inflation (b) a risk (or insurance) premium in case of unexpected inflation (c) a liquidity premium, because real return bonds are slightly less liquid than nominal bonds. I personally estimate the liquidity premium at less than 0.1%, although we saw it skyrocket at the end of 2008. The unexpected inflation premium I would put at 0.5%, although I've seen estimates as high as 0.8%. That would imply estimates of expected inflation in the 1.3% to 1.6% range. Coincidentally, that's quite close to consensus estimates based on all those professional (and highly-paid) forecasters.

George

[bones1]

Sigh... maybe I'll go with provincial strips in the 10-year range, for now. I don't want to lock in for 25 years at these rates, but sitting in cash is killing me. I can't see the federal government allowing any province to default on its bonds, so the premium of the provincial bonds seems quite attractive. In 10 years, I expect rates will be a lot higher than they are now.

[squid]

Last time I bought any was at the end of 2008, when the real yield rose to 2.4%, as I recall. Perhaps similar bargains will be available during the next financial crisis.
George

So was this because investors didn't expect real growth in the economy, so the difference in yield between the types of bond narrowed?

From this link: http://blog.canadianbusiness.com/time-to-buy-inflation-protected-bonds/ it seems that the premium you pay in having the inflation protection (yield given up) is below the historical norm, thus RRBs are a bargain to nominal bonds relatively speaking. Then, of course, maybe ALL bonds are bubbly right now. But, if your assumption is that prices might fall as yields rise due to economic recovery, I think that RRB would do fairly well in that scenario.

[newguy]

So was this because investors didn't expect real growth in the economy, so the difference in yield between the types of bond narrowed?

Or people were selling whatever they had that was still worth something.

newguy

[George$]

So was this because investors didn't expect real growth in the economy, so the difference in yield between the types of bond narrowed?

Or people were selling whatever they had that was still worth something.
newguy

In late 2008 liquidity was a real problem for folks who had margin calls in short selling or hedging. I think both the Caisse in Quebec and UofT (and other no doubt) had to raise cash and so sold their RBBs. I wish I had noticed the yield increase in time and bought some more RRBs.

[bones1]

Is there a site that gives current pricing for RRBs? This one I used to use no longer has any info for the real-return bonds:
http://www.pfin.ca/canadianfixedincome/Default.aspx

My brokerage account doesn't have electronic pricing for RRBs either. (You have to call the bond desk.)

[Shakespeare]

http://www.globeinvestor.com/servlet/Pa ... ype=fedgov

The prices seem a bit high, and may represent the ask.

[bones1]

http://www.globeinvestor.com/servlet/Page/document/v5/data/bonds?type=fedgov

The prices seem a bit high, and may represent the ask.

I checked out that site, vs. getting an over-the-phone quote.
2031 RRB on the site today quotes 1.25% real yield.
The bond desk guy quoted me 1.232% yield for the same bond.

So, it's pretty close. The difference may be because the web site is quoting me yesterday's prices?

[Shakespeare]

The difference may also be a higher spread on retail amounts. Hard to tell.

[northbeach]

1.232% yield does sound all that bad given current GIC rates. Afterall, I get 1.232% plus the inflation rate on an increasing yearly principal amount (if there is inflation).

I need to buy a GIC and am trying to figure out if I should add to my RRBs (something I have been wanting to do, but low rates have stopped me) or take out a 5 year GIC.

I know that it is difficult to compare RRBs to short term GICs, but does anybody have any suggestions for me.

[bones1]

For a bit more yield pickup, you can buy an Ontario real-return bond. The difference in yield for the same maturity date is an extra 0.36% for the Ontario ones, based on the quote I got over the phone. That makes the real yield more palatable. It's a bit riskier, but it's the same gamble you take when you buy provincial bonds over Canada bonds. IMO, I don't think the federal government will let any province go bankrupt, and very unlikely they'll let Ontario go broke (where all the votes are, and is likely to cause a financial panic). They'll just print money to bail them out (which is good for real-return bonds anyway).

[scomac]

1.232% yield does sound all that bad given current GIC rates. Afterall, I get 1.232% plus the inflation rate on an increasing yearly principal amount (if there is inflation).

I need to buy a GIC and am trying to figure out if I should add to my RRBs (something I have been wanting to do, but low rates have stopped me) or take out a 5 year GIC.

I know that it is difficult to compare RRBs to short term GICs, but does anybody have any suggestions for me.

Why not a provincial strip? A quick scan of my discounter has a 10 yr. Prov. of BC strip with a YTM of 3.949% on $10K of face.

[bones1]

Why not a provincial strip? A quick scan of my discounter has a 10 yr. Prov. of BC strip with a YTM of 3.949% on $10K of face.

I guess it depends on the duration you want. If I'm going really long, I prefer RRBs, because I have no idea what inflation might be 10+ years from now. If I'm going under 10 years, I'll usually stick with provincial strips, because inflation in the mid-term seems to be under control.

My main concern about inflation in the long-run, is government devaluing the currency by printing their way out of debt. When all those baby-boomer government workers want to start collecting their pensions, I see it as a way of government getting around the pension indexing rules. I believe indexing is capped at something like 6%. (Or there's some formula to cap the indexing of pensions during hyper-inflation.)

Also, there's the obvious debt problem, as well. In the past, whenever governments have faced large debt, they've just inflated their way out of it. I suppose if I was really sure that was going to happen, I'd short long nominal bonds. But, I have no idea how to do that cheaply, and I'm more into security than I am into gambling.

[Shakespeare]

I believe indexing is capped at something like 6%.

AFAIK the indexing is not capped.

[ghariton]

I believe indexing is capped at something like 6%.

AFAIK the indexing is not capped.

Correct. Federsl pensions are not capped.

Nor are they reduced in times of deflation.


George

[bones1]

Correct. Federsl pensions are not capped.

George

That's quite an amazing deal, if they really have no cap whatsoever. But in any case, they will be capped at some point. Trudeau did it, and if a left-wing socialist like he would do it, so will any prime minister in times of high inflation and high debt.

Government pensions will be way down the list of things governments will tackle, but it will have to be done at some point in the next 20 years. Taxpayers (and thus voters) will have little desire to fund a high lifestyle of retired public servants, when it's clearly an insane perk compared to non-government workers.

[northbeach]

In my earlier post I wondered if I should buy a 2031 RRB or a 5 year GIC. I do appreciate some of the suggestions I receive.

In the end I went for the GIC paying 3.05%.

My portfolio holds 12% RRBs and I figured that was the correct amount for me. For non inflation protected investments, I did not want to go out past 5 years, so stayed away from provincial strips with their higher rates.

[ghariton]

But in any case, they will be capped at some point. Trudeau did it, and if a left-wing socialist like he would do it, so will any prime minister in times of high inflation and high debt.

Did he? I have no recollection of it. He did impose wage and price controls of 6% and 5%, but those were widely held to be ineffective and were quickly removed. I very much doubt we will see their like again, within my lifetime anyway.

Taxpayers (and thus voters) will have little desire to fund a high lifestyle of retired public servants, when it's clearly an insane perk compared to non-government workers.

I agree that federal pensions will be made less attractive at some point. But I'm willing to bet that this will be done by lowering benefits or increasing contrributions for new hires, not by reducing benefits for existing employees, or at least not retroactively. The most likely measure is to increase retirement age to 67, say, and to no longer allow retirement on an immediate pension at 55. Reducing inflation indexing would be the absolutely last measure, in my opinion. The reason is that tampering with the pension plan will only be done in time of crisis, when savings are needed right away. Any savings from reducing inflation indexing would take many years to amount to much.

Indexing on RRBs is even safer than indexing on federal pensions. Removing the indexing would amount to a partial default, with all that implies.

George

[Shakespeare]

to no longer allow retirement on an immediate pension at 55

You can get a "reduced allowance" at 50, which works out to be 50%. I was told that technically it wasn't a pension, but it still qualifies for the pension tax exemption.

And, yes, I have one, although it's a small part of my income. One of the main advantages of taking it immediately is a continuation of hospital insurance benefits.

[ghariton]

I was told that technically it wasn't a pension, but it still qualifies for the pension tax exemption.

Correct. It's called an "allowance" rather than a pension. I can't see any difference whatsoever, but there may be historic reasons for the different label.

I was too terse, as so often. Today, a federal public servant can retire at 55 and start drawing a pension immediately, without any reduction, if he or she has 30 years of service. The same is true for any age above 55 if the sum of age and years of service adds up to 85 or more.

So for the lucky (or, IMHO, unlucky) person who joins the public service at age 25, he or she can retire at 55 on 60% of the last five years' average salary, fully indexed for inflation, for the rest of his life -- 20 or 30 years. When both members of a couple do this, that can easily produce a combined pension of $100,000 at an age when a second career is still a possibility. Ottawa may not have many rich inhabitants, but it sure has a lot of comfortably off ones.

It takes a lot of RRBs to duplicate that.

George