We are often asked our opinion on inflation and inflation protection products. And as with most economic related questions, timing is really the key. Is now a good or bad time to look at adding inflation protection products to your portfolio? Before we answer, let’s look at what inflation is, and a few different investment options.
Inflation in Canada is based on the Consumer Price Index which has eight categories:
- Household operations, furnishings and equipment
- Clothing and footwear
- Health and personal care
- Recreation, education and reading
- Alcoholic beverages, and tobacco products.
Each of the above categories has a different weighting within the CPI. As a simple illustration, food has a greater weighting over clothing and footwear, because most people spend more on food.
Let’s say in 2006 that Jack goes shopping for the day. He picks up groceries, fills his truck up with gas, gets a haircut, and buys a new pair of shoes. The entire shopping experience cost him $374.
In 2009 he went out and bought the identical groceries, put the same amount of litres in his gas tank, got another haircut, and another pair of shoes. This time the total bill came to $412.
The change in the price of these goods can be boiled down to inflation.
In 2006 Jack was earning $63,200 annually, and in 2009 his income is expected to be $69,621. In Jack’s case, his income kept pace with inflation.
Charlie retired at age 65 in 2006 with a government pension and all of his savings in a simple savings account at the bank. Overall inflation has been relatively low since he retired. Recently he has been hearing a lot about inflation and is getting worried. We explained to Charlie that CPI is used to index his company pension, CPP and OAS. These parts of his income flow are protected. The portion of his financial situation, exposed to inflation, is the $400,000 he has in the bank earning little to no interest.
If costs rise significantly in the future, the amount he has in the bank will purchase less than what it could purchase now. One option Charlie has is to look at purchasing some investments that may better protect him, if he is willing to assume a little risk.
Charlie has specifically asked us about Real Return Bonds. After all, he has read that bonds are less risky and RRBs protect against inflation. In our opinion we do not feel RRB will be the best option for Charlie over the short term. With the absence of inflation, RRBs function similarly and are influenced by the market very similar to long-term bonds. In our last article, we discussed what happens to long-term bonds when yields rise – they decline in value.
If yields do rise as forecasted over the next year, we feel it will not be solely because of inflation. We feel that if real yields rise, part of this will simply be based on the fact that we are at 50-year lows and the economy is recovering. RRBs will likely trade similar to extremely long duration bonds and will be quite volatile. Many investors are being told to buy RRBs because inflation will rise. Sure, it will rise eventually, but we feel the potential for large losses exist based on the long duration associated with most of these investments.
Another possible outcome is that yields rise as a component of both inflation and real yields. In this particular outcome, RRBs will likely outperform the nominal long bond of comparable term. But it is also likely in that scenario that short-term bonds would outperform both!
To illustrate our point, one only has to look at some of the Real Return Bond products available. In December 2008, many of these products hit a low and have posted nice returns since that date. The returns have been positive although inflation has been negative.
What has caused the positive returns? Interest rates have declined since last December causing a profit in most RRB products plus the demand for inflation protection products.
It would be extremely hard for the average retail investor to diversify by purchasing individual real return bonds. These bonds are generally picked up in the institutional market. A more practical way to obtain exposure to Real Return Bonds is to look at an investment such as iShares CDN Real Return Bond Index Fund (XRB). This fund holds a basket of real return bonds and has a low management expense ratio (0.35%).
XRB has a current yield of 2.7 per cent. To illustrate our point with long-term bonds, 98 per cent of the holdings within XRB have a maturity of ten years or greater. The weighted average term is 21.23 years with a weighted average coupon of 3.62%. We are at fifty-year lows when it comes to interest rates – they can only move up from current levels. If you have a short-term time horizon and an active strategy, we do not feel now is a good time for RRBs.
If an investor has a long-term time horizon and wishes to use a passive strategy (buy and hold) then RRBs generally make sense for a portion of a portfolio. Typically, this type of portfolio would hold a flat percentage of their holdings within RRBs, such as five per cent. In Jack’s case, with a $400,000 portfolio he would hold approximately $20,000. We would not encourage overweighting RRBs. As with other bonds, they are generally best held in a registered account, such as an RRSP or RRIF. RRBs may help protect the purchasing power of a portion of your portfolio. The key component that will impact performance is the change in interest rates.
For protection within non-registered accounts, we prefer holding a small portion in gold, agriculture, and energy common shares. Several types of preferred shares also provide some inflation protection along with tax efficient dividend income suitable for taxable accounts.