These bonds help fight stagflation
Jonathan Chevreau The National Post Saturday August 23, 2003
Ask for genuine real return bonds, not similar products

Predicting inflation rates seems as futile as divining short-term moves in the stock market or interest rates.

Long bonds have been devastated the past two months on fears of renewed inflation; yet this week Statistics Canada reported the year-over-year annual inflation rate fell to 2.2% in July, from 2.6% in June.

Thus, while the U.S. Federal Reserve stood pat last week on interest rates, experts now expect the Bank of Canada will be forced to cut Canadian rates early in September.

All this leaves investors in limbo. Some, such as financial advisor and author Stephen Gadsden, suggest we may see a return of 1970s style "stagflation."

For those who have forgotten the term, stagflation occurs when an economy suffers both slow growth and high unemployment (stagnation) at the same time consumers are saddled with rising prices and interest rates (inflation).

"I think we will experience renewed inflation or maybe even stagflation," says Barry Cook, a private investor in Victoria, B.C., who has developed his own solution to the dilemma. Read on.

Those investing for the long haul -- notably retirement -- assume governments will always choose inflation over deflation. History confirms this: over the 89 years from 1914 to 2003, the average annual compound rate of inflation in Canada was 3.23%. [See the inflation calculator at http://www.bankofcanada.ca/en/inflation_calc.htm.]

Since 2000, "Sir Prints a Lot" (Alan Greenspan) has been aggressively lowering interest rates and printing dollars in the wake of the tech meltdown and 9/11. Deflation fears keep him from raising rates.

The bond market rout suggests he may succeed, but Greenspan's massive, sustained monetary stimulation has reawakened old inflation fears for bondholders. Long-term yields have risen and bond values have fallen. (The two are inversely related).

It doesn't take the kind of hyperinflation Germany suffered in the 1920s to savage bond values and currencies. Even moderate inflation of 3% to 5% will do severe damage over time. Since most governments are off the gold standard, politicians have no constraints against further debasing their currencies: even the once mighty U.S. greenback has shown signs of weakness, both against other currencies and gold.

The equity cult of the 1990s was based on the belief stocks (or equity mutual funds) are the only asset class which can consistently beat inflation. But investors forget stocks did not do well through the inflationary 1970s.

Furthermore, stocks are not risk-free even over the proverbial long run, says a recently published book: Worry Free Investing: A No-Risk Approach to Achieving Your Lifetime Financial Goals, by Michael Clowes and international pension expert Zvi Bodie.

Bodie focuses on a new type of bond which did not exist in the United States before 1997 -- Treasury Inflation Protected Securities (TIPS) and tax-deferred Inflation Bonds.

Canada pioneered this concept in 1991 with Government of Canada Real Return Bonds (RRBs).

RRBs pay inflation-adjusted interest semi-annually. At maturity, they repay the principal in real inflation-adjusted dollars, which is why they should be held in RRSPs.

RRBs have similar expected returns but less risk than long-term bonds. The interest rate sensitivity or price volatility is more like short-term bonds.

However, Canada does not yet have Inflation Bonds, which provide tax deferred, inflation-adjusted returns for non-registered accounts. A petition for their introduction is at http://canadianinvestor.tripod.com/canadianibonds/id12.html).

Cook, who gave Bodie a back-cover endorsement, has long invested in RRBs in his RRSP and is part of the grassroots movement pushing Ottawa to create Inflation Bonds or introduce Tax Prepaid Savings Plans (TPSPs) so investors can safely hold RRBs in non-registered accounts.

Most investors under 60 should consider using RRBs for the long-term portion of their portfolios, Cook says. "RRBs are far less volatile, better portfolio diversifiers and are not subject to nominal interest rate risk."

In his Dow Theory Letters , veteran market analyst Richard Russell notes the yield of the 10 year T-note reached 4.39% last week, compared to 2.08% for the 10-year TIPS. The 2.08% differential is the widest spread this year. His conclusion: the bond market sees average inflation rising to 2.08% over the next 10 years, up from prior expectations of 1.4%.

While some advisors, including Gadsden, recommend new RRB bond funds from TD Bank and others, Cook says those with more than $20,000 should bypass the bond fund MERs and buy RRBs directly from brokers or banks. There are issues maturing in 2021, 2026, 2031 and 2036.

For details on how to buy them, see Real Return Bonds for Dummies at www.bylo.org.

RRBs should be considered as a separate asset class complementary to a short-term bond ladder. Those wanting liquidity or retirement income can also hold GICs or corporate bonds. Both can be laddered over one to seven years, Cook says.

"The recent meltdown in long-term rates would not affect these shorter hold-to-maturity issues. If interest rates go up that's terrific. So will your bond income as you reinvest the maturing issues."

Those unconvinced inflation will eventually trump deflation can hedge their bets by holding half of their long-bond allocation in RRBs.

You may find resistance when you ask your broker to buy you RRBs. Not all are familiar with them and some are less than enthusiastic, a notable exception being National Bank Financial's Andy Filipiuk.

More typical is Merrill Lynch Canada's commentary issued after July's inflation numbers came out. Entitled "RRB bulls beware," it trumpeted recent inflation data as a positive and evidence there is no need for RRBs.

Keep in mind brokers get far less compensation from RRBs or nominal bonds, and that once the initial sale is made, they'll reap little more from them. That's why some may try to talk you instead into RRB bond funds or other products paying them annual fees.

Don't let them. When it comes to RRBs, adopt the old saying "Accept no substitutes."

 

[Home | Back | Forward | Archive | ContactUs | Disclaimer | Glossary | Links | Search]