Real-return bonds get support from investors

(January 28, 2004) Real-return bonds (RRBs) have received a vote of confidence from investors in a round of consultations carried out by the Bank of Canada. Both institutional and retail investors expect demand for RRBs to remain strong and say the federal government should continue to issue them.

The central bank called for comments on its RRB program last fall. More than 50 stakeholders responded. RRBs pay a rate of return that is adjusted for inflation.

“Overall, market participants were of the view that RRBs provide value and that the government should continue to issue them,” the Bank of Canada said. “Participants suggested that current and future demand for RRBs would be robust mainly because of strategic investment by firms and individuals with inflation-linked liabilities and because of the diversification benefits that RRBs provide.”

The vast majority of participants characterized RRBs as buy-and-hold investments, the central bank said. Pension funds, the largest holders of RRBs, use the product to match long-term, inflation-sensitive liabilities.

“A number of participants noted the risk diversification benefits of RRBs: they allow fund managers to take on more risk in other asset classes,” the bank added.

Demand for RRBs surged in the recent past, the bank said, citing the three-year bear market and increasing strategic and tactical decisions regarding asset allocation.

Most survey participants said they expected demand to increase further, as the mandates of pension funds, endowment funds and foundations increasingly include RRBs for matching liabilities.

Analyst Dan Hallett says the continuing popularity of real-return bonds may come down to basic supply-and-demand fundamentals.

“That can be very powerful and could be used to build a very strong case for why demand for RRBs and long-term bonds will continue to increase,” he says. “Demographic trends play into this story, as well, with the aging population and the likely resulting increase in demand for income-producing assets.”

“The one thing that bodes well for RRBs going forward is that the bond market has a spotty record projecting future inflation — though admittedly that could go the other way as well,” Hallett adds.

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Since the price of RRBs matches rising inflation, they’re an excellent tool for portfolio diversification, said researcher Levi Folk in an article written for Advisor.ca last year.

But do RRBs make sense in this current cycle of low inflation? Folk believes they do.

“Investors with long-term horizons should look well beyond the current economic cycle to determine their appetite for RRBs versus nominal bonds,” Folk wrote. “The reality of near double-digit inflation throughout the 1970s was a hard pill to swallow for bond and equity investors, who suffered real losses in both asset classes.”

Had real-return bonds been available then, they would have provided a haven from the ravages of inflation, Folk said.

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So, do RRBs make sense right now? When do they make sense and when don’t they? Share your thoughts about this product with your fellow advisors in the “Mutual Funds and Other Products” forum of the Talvest Town Hall on Advisor.ca.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com

(01/28/04)

Doug Watt