Out of harm's way

Out of harm's way
Diane Maley • The Toronto Star • Saturday, February 22, 2003

Canadian and U.S. governments offer bonds that protect investors' purchasing power from inflation. Since 2000, these bonds have rewarded investors with a return of 30 percent a year.

Three years ago, at the height of the great stock market bubble, Al Friedberg advised his clients to buy inflation-protected government bonds.

"What a gamble that was at the time," recalls Michael Hart, chief bond trader at Friedberg Mercantile Group. "People didn't understand them. They gave you that real sideways look when you mentioned them."

Investors were still mesmerized by the stock market, which went on to rob them of a cool $13 trillion (U.S.) worldwide.

Friedberg favoured TIPS, or Treasury inflation-protected securities, issued by the U.S. government, although he also bought Government of Canada real return bonds, or RRBs. Since then, the bonds have rewarded investors with a return of 30 per cent a year.

For Friedberg, who also trades in currencies and commodities, it was an unusually cautious call.

Yet it wasn't that long ago people saving for retirement would stash their money mainly into government bonds. The Canada Pension Plan could buy nothing but bonds because Ottawa didn't want to take chances with people's pensions. With bonds, you know exactly how much money you are getting if you hold them until they mature.

But you don't know what that money will buy.

In the 1950s and 1960s, people were comfortable investing their hard earned savings in safe, secure government bonds. Then came the great inflation of the 1970s. Prices rose year after year, peaking at an inflation rate of more than 12 per cent in 1980. Suddenly people's nest eggs could buy less than before. Inflation had eroded the purchasing power of bonds and pensions.

Governments pondered the problem and came up with a nearly perfect solution: bonds whose purchasing power is protected from inflation. Ottawa and the U.S. Treasury brought these inflation-protected bonds to market just about the time inflation fell into a long swoon.

"They're a very good long-term asset to hold," says Doug Porter, senior economist at BMO Nesbitt Burns. "For many people, they could form a core component of an RRSP. You really know what you're getting for the long term." But with inflation low and falling, people largely ignored the new bonds; they were undervalued.

Friedberg figured that when "real" or inflation-adjusted interest rates — bond prices minus inflation — returned to their historic norms, inflation-protected bond prices would explode.

Explode they did.

While the bonds have had a good run, the folks at Friedberg think they have some life in them yet.

"Real rates of return are collapsing, so the bonds should do well over the next 12 months," Hart predicts. "They still have a ways to go."

Before you buy inflation-protected bonds, you have to believe inflation will persist and even pick up in future. Lately, some economists have been raising the terrible spectre of deflation.

RRBs are designed for people who want a "true hedge against inflation," says Satish Rai, co-manager with Geoff Wilson of the TD Real Return Bond Fund, one of the few such funds in the country. "If you feel there will be deflation, this is probably not a product you would want," Rai says.

Indeed, if we were to suffer net deflation, you could end up receiving less money for your RRBs than you started with when the bonds mature because their face value will be adjusted downward for deflation. Still, your purchasing power will have been preserved.

In Al Friedberg's opinion, deflationary fears are unfounded.

The steady fall of the U.S. dollar, rising money supply growth, big tax cuts and "the near certainty of at least one war make nonsense of the fears of deflation," Friedberg writes in the firm's latest newsletter. "In fact, we firmly believe we are in for the most sustained period of rising prices since the early '70s."

If you are spooked by deflation fears, you can buy TIPS instead. Unlike Ottawa, the U.S. government guarantees that investors will get their full principal back regardless of deflation. TIPS can be held in the foreign content portion of your RRSP, which is up to 30 per cent of the total.

Bonds are relatively complicated creatures and TIPS and RRBs are even more so because of the inflation-adjustment formula. Detailed information about them, along with many useful links, is available online under "Real return bonds for Canadian dummies" at http://www.bylo.org/rrbs.html.

Here's how they work.

RRBs pay interest semi-annually based on a "real" interest rate. Interest payments are adjusted for changes in the consumer price index, or CPI. RRBs pay you two ways: an inflation adjusted interest rate semi-annually; and a principal at maturity, or when the bonds are sold, that is adjusted for accumulated inflation.

Here's an example from the Web site.

On a $1,000 bond, if the coupon interest rate is 3 per cent and inflation is 1 per cent after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3 per cent by year end, the principal is adjusted to $1,030. You then receive another interest payment of $15.45. Assuming similar inflation over 10 years, you will receive $351.64 in interest payments while the principal will have risen to $1,343.92.

There are risks. Like regular bonds, RRBs and TIPS can be buffeted by changes in interest rates. If interest rates were to rise steeply, bond prices, including RRBs, would fall. If you had to sell, you would lose money. But their prices are less volatile than long-term bonds that are not inflation-protected.

If inflation remains low, or if the economy slips into deflation, you'd have been better off buying a conventional bond because its coupon — or interest payment — would have been higher.

You can buy TIPS and RRBs from investment dealers, discount brokers or currency dealers such as Friedberg. Although the Canadian government's Web site says they are available in denominations of $1,000 and up, most dealers will want at least $5,000.

For a minimum investment of $5,000, Friedberg offers a low-cost way to diversify your holdings, the Friedberg Foreign Bond Fund, which invests in TIPS, RRBs and euro-denominated French inflation-protected bonds with a current yield of about 3.4 per cent. The fund returned 18 per cent last year and has a management expense ratio of 0.93 per cent. It can be held as foreign content in an RRSP.

The TD Real Return Bond Fund returned 15 per cent last year and a compound average of 9.6 per cent a year over the past three years even after subtracting its hefty 1.65 per cent management expense ratio, Rai says.