# Real Return bonds



## Albert (Jan 19, 2012)

What is happening with real return bond ETF. I was away for a couple weeks and on my returns notice that iShares DEX Real Return Bond Index Fund dropped drastically. I know there was a move on the bond market, but never thought it would effect these funds that much. Any comments are appreciated.


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## HaroldCrump (Jun 10, 2009)

Real return bonds usually are high duration bonds, and are thus very sensitive to long rates.
Long rates have been rising in the last 30 days, and thus the bond value would have dropped.
The market is expecting inflation in the long run given the recent statements and hints by the US Fed.

You have to understand that for the past several years, RRBs have been priced with almost zero inflation expectations.
That had to change at some point....the birds are now coming home to roost.


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## My Own Advisor (Sep 24, 2012)

Don't own any myself (RRBs), XRB has an average duration of 20 years. That's long.


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## CanadianCapitalist (Mar 31, 2009)

Here's an excellent tutorial on Canadian Real Return Bonds from Bylo:

Real Return Bonds for Canadian Dummies


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## My Own Advisor (Sep 24, 2012)

Good link.


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## GoldStone (Mar 6, 2011)

Recent article in G&M:

*Why contrarians may want to bet on real return bonds*
http://www.theglobeandmail.com/glob...s-economy-lowers-bond-prices/article12727648/

According to the article:

1. bond yields have been rising because market expects economic expansion which leads to higher real yields.
2. inflation and expected future inflation remain low.

Real return bonds dropped because real yields have risen.

Note the difference between this explanation and Harold's.

bond yield = real yield + inflation premium + risk premium

Bond yields can increase due to higher real yields, without inflation expectations going up.


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## Albert (Jan 19, 2012)

Thanks for the info. Now I got to decide whether to dump then, while I still have a gain or keep, since for the moment the worst seem to be priced in.


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## HaroldCrump (Jun 10, 2009)

Albert said:


> for the moment the worst seem to be priced in.


Don't make that assumption.

Ask yourself - why are you holding RRBs?
What are they doing for your portfolio?
Are you holding them for any particular upside? If so, what is your theory around that?
Or are you holding them as a hedge against something (perhaps inflation)? How is that working out?
How are they going to behave under various market conditions (rising long rates vs. more Q/E vs. Twist vs. rising inflation vs. deflation, and so on).

Unless you are confident in your answers to such questions, it is dangerous to hold such products in your portfolio.

The damage caused to a bond portfolio can sometimes be worse than stocks, and it is much harder to recover from a damaged bond portfolio than it is to recover from a stock portfolio, because long bonds have long cycles.


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## Albert (Jan 19, 2012)

Thanks Harold for the wise comment. Sharing your knowledge and experience is appreciated. I will review why I am holding RRBs and decide.


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## GoldStone (Mar 6, 2011)

An individual RRB is easy to analyze. You buy it and hold it until it matures. You get a stream of inflation-adjusted coupon payments as long as you hold. When the bond matures, you get your inflation-adjusted principal back. You can safely ignore market price fluctuations if you plan to hold until maturity.

RRB ETF is much less straightforward.


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## james4beach (Nov 15, 2012)

HaroldCrump said:


> The market is expecting inflation in the long run given the recent statements and hints by the US Fed.


This is just one theory but we can't assume this is what's happening. The G&M article points to expected economic expansion, another theory.

It's not clear what's happening to bonds and why bond prices are dropping so sharply (this is happening simultaneously in many countries at once, including emerging markets). Bond experts are stumped too. Here are the theories I'm aware of

a) Market is predicting that higher inflation is coming

b) Market is predicting that the economy is improving

c) The central bank stimulus of the last few years pumped lots of money into the bond market. Both through direct Federal Reserve purchases of bonds (QE), ECB purchases of bonds across Europe, and due to others chasing the central bank money into all kinds of bonds. For evidence of that just look at the yield chasing into things like corporate and junk bonds that pops up repeatedly throughout our forums here. Through 2012, bonds were very expensively valued ... artificially so, due to all this stimulus and central bank manipulation. Like any other bubble, this requires certain expectations to continue chugging along as new buyers are paying ever higher prices. It seems that these expectations may have broken this month, with the Federal Reserve not saying they will expand their bond buying further. This suddenly makes bonds very unattractive, since the only reason for buying bonds at current prices was the expectation that central banks would keep their prices high.

Personally I think (c) is at play now. I don't see inflation on the horizon but I think the over-heated bond market is cooling off as bubbles inevitably due. It may come roaring back though, if central banks indicate they want to buy more. This is not a normal market; it's heavily manipulated by central banks.


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## fatcat (Nov 11, 2009)

i think bonds are getting dumped out of irrational fear ... nothing makes sense

if we are expecting better economic times, why sell equities ?
if we are expecting inflation why sell gold ?

this selloff looks more like people are afraid of deflation
why sell bonds if we are going into deflation ?

if the fed is keeping interest rates very low for the foreseeable future and companies are flush with cash (i.e. nobody needs money) why are yields even rising ?

harry browne said:
own gold for inflation
own bonds for deflation
own stocks for expansion
own cash for contraction

yet we see all the first 3 all getting creamed ... so i guess we are going into contraction ... have i got that right ?


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## HaroldCrump (Jun 10, 2009)

Real Return Bonds are a worthless "protection" against _real_ inflation.
If a retiree or a near retiree is holding RRBs as a cost of living inflation hedge, they have been getting ripped off.
Look at the cost of food, gasoline, hydro and other core living expenses in the last 5 years or so, and then look at the yields of RRBs.
The YTM of the XRB is 0.84%.
How is that "inflation protection" working out for ya?


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## james4beach (Nov 15, 2012)

fatcat said:


> i think bonds are getting dumped out of irrational fear ... nothing makes sense
> 
> if we are expecting better economic times, why sell equities ?
> if we are expecting inflation why sell gold ?
> ...


I think the possible reason (c) I give above makes sense.

Your reasoning misses the possibility that central bank stimulus (QE and ZIRP) has been the driver behind _all assets_ going higher. It's pushed up stocks, commodities, and bonds simultaneously in the last few years. And remember this has been very explicit in the case of bonds... the Federal Reserve and ECB buy bonds!

I think the explanation of central-bank-driven-bond-bubble makes the best sense.


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## scomac (Aug 22, 2009)

HaroldCrump said:


> Real Return Bonds are a worthless "protection" against _real_ inflation.
> If a retiree or a near retiree is holding RRBs as a cost of living inflation hedge, they have been getting ripped off.
> Look at the cost of food, gasoline, hydro and other core living expenses in the last 5 years or so, and then look at the yields of RRBs.
> The YTM of the XRB is 0.84%.
> How is that "inflation protection" working out for ya?


That's the real yield that is being quoted Harold. In nominal terms it would be CPI+0.84%.

To answer your question, the inflation protection has worked out just fine over the past five years and considerably better than if I had held nominal bonds of comparable credit quality and duration.


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## fatcat (Nov 11, 2009)

james4beach said:


> I think the explanation of central-bank-driven-bond-bubble makes the best sense.


you are not alone in that assumption ... i believe the term is "financial repression" ...

i am only an amateur when it comes to understanding financial markets but even i can see that what has happened over the last few years and the last two days last week makes no sense ... the usual laws that govern markets no longer apply here


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## HaroldCrump (Jun 10, 2009)

scomac said:


> In nominal terms it would be CPI+0.84%.


But CPI is currently around 0.70%.
It had been as high as 1.2% sometime last year and has dropped below 1% most of this year.
Either way, you are looking at less than 2% nominal yield.



> To answer your question, the inflation protection has worked out just fine over the past five years and considerably better than if I had held nominal bonds of comparable credit quality and duration.


RRBs work best in a _rising_ CPI scenario.
i.e. you buy in when CPI is low[er], and then wait and watch as CPI rises.
However, those that have bought into RRBs in the last couple of years, have paid peak valuation IMHO.

In a rising CPI and/or rising long yield scenario, an existing portfolio of RRBs will suffer badly.


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## james4beach (Nov 15, 2012)

fatcat said:


> i am only an amateur when it comes to understanding financial markets but even i can see that what has happened over the last few years and the last two days last week makes no sense ... the usual laws that govern markets no longer apply here


I agree that the usual laws don't seem to apply any more (this started around the year 2009). There are very heavy distortions in markets due to central banks doing weird, historically unprecedented things.

It's the main reason I haven't invested in stocks for years and why I choose to opt out of the market. I don't like participating in a heavily manipulated, distorted market.


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## fatcat (Nov 11, 2009)

james4beach said:


> I agree that the usual laws don't seem to apply any more (this started around the year 2009). There are very heavy distortions in markets due to central banks doing weird, historically unprecedented things.
> 
> It's the main reason I haven't invested in stocks for years and why I choose to opt out of the market. I don't like participating in a heavily manipulated, distorted market.


forgive me for pointing this out but you just bought a canada 10 year note on which you are also getting creamed, correct ? ... there is no safe harbor here ... cash is king


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## james4beach (Nov 15, 2012)

fatcat said:


> forgive me for pointing this out but you just bought a canada 10 year note on which you are also getting creamed, correct ? ... there is no safe harbor here ... cash is king


I did buy the 10 year bond, but I always hold those to maturity. Yes the account shows a loss but since I hold it to maturity, the yield-to-maturity is guaranteed. As I ladder these things over time there is no way I can suffer a loss. I know my exact total return the moment I buy a bond. The bonds I buy go into the same ladder along with the GICs, I treat them the same and they can't lose money.

But yeah the bond prices are another example of that heavy distortion. I don't like it, but that's the environment we live in. I stuck with my bond investments because the returns are still guaranteed and the risks are much, much lower than investing in stocks or commodities.

However I have repeatedly said in these forums that I would NOT buy a bond fund or bond ETF of any kind. That's due to all these distortions and market weirdness.


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## fatcat (Nov 11, 2009)

james4beach said:


> I did buy the 10 year bond, but I always hold those to maturity. Yes the account shows a loss but since I hold it to maturity, the yield-to-maturity is guaranteed. As I ladder these things over time there is no way I can suffer a loss. I know my exact total return the moment I buy a bond. The bonds I buy go into the same ladder along with the GICs, I treat them the same and they can't lose money.
> 
> But yeah the bond prices are another example of that heavy distortion. I don't like it, but that's the environment we live in. I stuck with my bond investments because the returns are still guaranteed and the risks are much, much lower than investing in stocks or commodities.
> 
> However I have repeatedly said in these forums that I would NOT buy a bond fund or bond ETF of any kind. That's due to all these distortions and market weirdness.


i read an article on zerohedge that makes a good case that now is the time to buy bonds

if people are unloading their artificially overheated bonds and signalling higher rates ahead why are equities tanking ?
i can see that case for a move back into all the assets that have just been tanking reits, utilities among them
where are people going to get yield ?

i think the only answer is to sit tight


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## andrewf (Mar 1, 2010)

It is possible for both bonds and equities to be overvalued vs cash today.


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## scomac (Aug 22, 2009)

HaroldCrump said:


> But CPI is currently around 0.70%.
> It had been as high as 1.2% sometime last year and has dropped below 1% most of this year.
> Either way, you are looking at less than 2% nominal yield.


Source please?



> RRBs work best in a _rising_ CPI scenario.
> i.e. you buy in when CPI is low[er], and then wait and watch as CPI rises.
> However, those that have bought into RRBs in the last couple of years, have paid peak valuation IMHO.
> 
> In a rising CPI and/or rising long yield scenario, an existing portfolio of RRBs will suffer badly.


So what is it, Harold; rising CPI is good for RRB's or it's bad for RRB's? You have just contradicted yourself above.

Bonds don't suffer badly if you hold them to maturity. You will still earn the return that you settled for when you purchased them. Sure there maybe an opportunity cost to holding something to maturity when an alternative yields better, however the cost to switch will render the advantage moot.

Real return bonds are held to hedge a fixed income portfolio against *unexpected* inflation. I would like to know how you propose to do such a thing without incurring considerably greater risk.


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## HaroldCrump (Jun 10, 2009)

scomac said:


> Source please?


XRB source showing current yields:
http://ca.ishares.com/product_info/fund/overview/XRB.htm?fundSearch=true&qt=XRB

CPI source showing current CPI of 0.8%:
http://www.statcan.gc.ca/daily-quotidien/130517/dq130517a-eng.htm



> So what is it, Harold; rising CPI is good for RRB's or it's bad for RRB's?


Depends on when you bought, right.
If you bought RRB when CPI is at its bottom, then rising CPI is bad for _you_ because the bonds will lose value.



> Bonds don't suffer badly if you hold them to maturity. You will still earn the return that you settled for when you purchased them.


Yep, that is true for any kind of bond.
Holding to maturity is the way to go, for sure.
Which is why I prefer direct bond holdings instead of ETFs.



> Sure there maybe an opportunity cost to holding something to maturity when an alternative yields better


Right, that is what I meant when I say bonds will lose value.



> Real return bonds are held to hedge a fixed income portfolio against *unexpected* inflation. I would like to know how you propose to do such a thing without incurring considerably greater risk.


IMHO, because the returns of RRBs are pegged against the entire country's CPI, they are not a good hedge against inflation at all.
There is no adjustment for provincial or local inflation, let alone your personal inflation factors.

If you want to protect against _unexpected_ *and* _average_ reported CPI, then yeah maybe it does what it's supposed to do.
But IMHO, is that a risk even worth protecting against?
Is inflation really _that_ unexpected?
Is the national average CPI inflation a risk significant enough to protect against, by accepting puny returns year after year?


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## james4beach (Nov 15, 2012)

I'm of the belief that everything is overvalued (stocks, bonds, commodities) due to central banks manipulating the prices of these assets upwards.


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