A hot topic for knowledgeable do-it-yourself investors is real-return bonds (RRBs), which are inflation-indexed Government of Canada bonds.

In the United States, similar securities are called TIPS (Treasury Inflation-Protection Securities). A report by Ibbitson & Associates -- TIPS as an Asset Class -- concludes that "in addition to their obvious appeal to investors guarding against increases in inflation, TIPS may also appeal to a broader audience by virtue of their relatively low correlation with other traditional asset classes."

In other words, when other assets are performing poorly, RRBs provide steady positive returns.

Just as exchange-traded funds (ETFs) were relatively unknown to the average equity investor two years ago, so too are RRBs today, even among financial advisors. And some who are familiar with the concept dismiss the need for such bonds on the grounds that inflation has been "licked."

But is inflation really dead? In my view, sooner or later all western governments resort to inflation as a way of escaping their self-created problems. Anyone who relies on investments for their income needs to hedge at least some of their bond portfolio against the possibility the inflation rate will creep higher.

As Keith Betty, a Lethbridge, Alta.-based private investor and retiree puts it, "the market anticipates. You have to out-anticipate it. The time to buy RRBs is before everybody is concerned about inflation."

Some influential financial authors have endorsed the concept.

"For those people who are very risk-averse, the inflation-indexed bonds can be the perfect investment," says Robert Shiller, a professor of economics at Yale and author of the book, Irrational Exuberance.

"Currently, these bonds have been paying around 4% a year, with absolutely no risk. Compare that with stocks, whose dividend yield is around 1%, and with lots of risk. It is one of those great puzzles why so many people think that the only attractive investment is stocks."

Even the guru most responsible for the 1990s Cult of Equity -- Jeremy Siegel, author of Stocks for the Long Run -- told Business Week he finds TIPS an attractive hedge against stock market fluctuations.

Betty believes a healthy portion of a fixed-income portfolio should be in RRBs, making a nice complement to a traditional "ladder" of bonds maturing at different times.

Betty sees RRBs as a replacement for normal 10-year bonds in an efficient portfolio.

"Those of us who have [non-RRB] bond ladders can shorten the ladder and use RRBs for the long component. If we use the December 2021 RRB, then its purchase can be made with a view to holding it to near maturity, when it may be sold to fund an annuity."

To learn more about RRBs, go to a Web page named Real Return Bonds for Canadian Dummies, at Bylo Selhi.

The site says RRBs provide two streams of payments:

1. Interest: On June 1 and December 1 bond-holders receive a payment for an amount equal to the inflation-adjusted principal multiplied by the interest rate.
2. Inflation adjustment: The principal or par value is continuously adjusted by an amount equal to the Consumer Price Index but is payable only when the bond is sold or matures.

One RRB believer on the Web --posting as Ellis Armsteinbogle -- says RRBs are "arguably the least risky financial investment available to Canadians."

Even so, he cautions that because these products are meant to be held for 20 years or more, investors should first make sure they understand the mechanics thoroughly.

Mutual fund investors can also access the TD Real Return Bond Fund. However, Betty points out that the fund's management expense ratio (MER) is an exorbitant 1.64%.

As well, because the fund holds only three Government of Canada issued RRBs with essentially identical returns "there is no diversification advantage whatsoever."

In Canada, current tax policy pretty well forces investors to hold RRBs in their RRSPs or RRIFs. The U.S. has a superior product called I bonds or Inflation bonds, which are tax-deferred even outside U.S. registered retirement plans.

As reported here last year, there is a populist movement to introduce Inflation bonds to Canada. Despite growing public support, this grassroots initiative appears to have fallen on deaf ears in Ottawa. More details, including a petition, can be found at Canadian I-Bonds.

Real Return Bonds (RRBs) are a wonderful hedge against both inflation and a stock-market downturn. But what about deflation?

Tuesday's column on Canadian RRBs mentioned the inflation-hedging similarities with American TIPS, or Treasury Inflation-Protection Securities. TIPS are selling briskly, The Wall Street Journal reported Wednesday.

But I didn't point out one major difference: The minimum face value protection feature American TIPS provide in the event of deflation does not apply to Canadian RRBs.

The final payment investors get from an RRB equals the principal plus an inflation compensation. If the latter is negative (i.e., in the event of deflation), final payment could be less than the original principal.

This interpretation can be found in a prospectus on RRBs at the Bank of Canada Web site [but not on SEDAR]. It says: "At maturity, in addition to coupon interest payable on such date, a final payment equal to the sum of inflation compensation accrued from the original issue date to maturity (whether positive or negative) and principal will be made."

The web page at Real Return Bonds for Canadian Dummies clarifies this is one risk of RRBs.

"Like nominal fixed-coupon marketable bonds, if you sell an RRB prior to maturity the price you realize will be based on the prevailing interest rate and could be less than what you originally paid."

If you buy an RRB on the secondary market, "it's possible that after a period of deflation you may receive a principal repayment that's based on a lower index ratio than when you bought the bond."

But even in the unlikely event of net deflation over the 30-year holding period, "your purchasing power would still be preserved. Indeed, if you had reinvested the coupons in more RRBs inside a tax-sheltered account, at maturity the purchasing power of your initial investment would have grown significantly."

These sources both downplay the possibility of multi-decade deflation, but the negligible inflation in Japan has opened eyes to at least the possibility of deflation occurring in North America.

In his Journal article, Greg Ip quotes a former U.S. inflation hawk as now fretting over disinflation or even deflation.

The president of the Federal Reserve Bank of Richmond, J. Alfred Broaddus Jr., changed his views after visiting Japan. In an April speech he said he will "be prepared going forward to focus on pre-empting disinflation, and more crucially, deflation."

This prompted me to dig out my 1998 copy of a prescient book by Gary Shilling, titled Deflation. It was written when the U.S. bull market was still roaring, but the recent bear action makes his maverick view more plausible now.

Shilling declared inflation "over" and deflation likely, even though few expect it. He predicted "chronic" annual deflation of 1% to 2%. He listed 14 deflationary forces, including shrinking government spending and deficits, technology and a switch by U.S. consumers from borrowing and spending to saving.

In deflation, Shilling says the winners are savers and lenders, renters, those on social security or fixed pensions, those with low financial leverage and "employees whose value to employers vastly exceeds their cost." Losers are big spenders, debtors, the highly leveraged and overpaid employees.

In a transition period, Shilling favours bonds over stocks. He foresaw 30-year Treasury bonds returning to 3%, which would mean "the bond rally of a lifetime." He suggested avoiding junk bonds and found utility stocks "interesting."

Bond investors can hedge against either inflation or deflation by holding a mix of RRBs and a ladder of strip bonds maturing in different years, says investor Keith Betty.

Ellis Armsteinbogle is the Internet handle of a Victoria-based investor spearheading a grassroots campaign to bring tax-deferred inflation bonds to Canada. (See Canadian I-Bonds.) He believes deflation is unlikely because inflation is built into the western financial system.

"Our central banks have a legislated mandate to grow our economy at a sustainable 2% to 3% real growth rate. Inflation fighting is a secondary function, sustainable growth is the primary goal. Inflation is insidious and relentless. It will always be Public Enemy No. 1 to all savers and investors."

Even if deflation occurs, Armsteinbogle says it would be irrelevant to RRB holders.

"You will always receive your guaranteed real return as well as the return of your inflation-adjusted principal. If inflation is zero or even negative you still do not lose. In the highly unlikely event your principal is negatively adjusted at maturity it is only because the total Consumer Price Index has fallen. Remember your goal is to not lose as a result of inflation, not to try and gain speculating on deflation."