All that glitters is not gold–real return bonds may not be as promised

Inflation is like toothpaste. Once it's out, you can hardly get it back in again.

– Karl Otto Pohl

We’re fielding many questions on real return bonds (RRBs) and how they can be used to offset some of the inflation risk in a fixed-income portfolio. Inflation seems to be on the tip of everyone’s tongue and front and centre when it comes to their worries. A Google search for the term yielded over seventy-two million news hits, and according to Google trends, the search term is at its all-time peak in terms of popularity for Canadians.

It’s not only an issue in Canada. The University of Michigan survey of consumer sentiment fell in early November to its lowest level in a decade. The decline in consumer sentiment was attributed to  an increase in prices of consumer goods and the growing belief that the policies in place today wouldn’t effectively address the surge in inflation.

The U.S. Consumer Price Index (CPI) for October came in above consensus estimates at 6.2% year-over-year and even perhaps more surprising at 0.9% month-over-month. But should we be surprised? After all, COVID-19 continues to linger and is increasing materially in certain areas around the world, which continues to impact supply chains. An increase in food and gasoline prices have also added fuel to the inflation fire.

Since the end of last year, our team has had a non-consensus view when it came to the inflation narrative, as we expected it to be more enduring than transitory. The broad belief was that much of the inflation earlier this year was due to base effects and that it would roll over once those base effects ended. We argued in our “The transitory inflation narrative continues … but is it real?” note that it wasn’t just base effects and that as the world reopened, the surge in demand would add to inflationary pressures.

But what is transitory?

The issue with the transitory narrative is that it was never really defined. Does the term reflect the expectation of time or level? We suspect that many market participants weren’t expecting inflation to remain above 5% after the base effects from the recession rolled over, never mind increase to the recent level. While we believe that we’re near or at peak inflation, we don’t believe that the drop will be immediate or by as much as many may think.

Our inflation model incorporates four factors: the price of oil, measured by West Texas Intermediate (WTI); wages (measured by the Atlanta Fed Wage Tracker); housing costs (measured by owner’s equivalent rent); and the U.S. dollar (measured by the DXY Index). When we enter levels that were last seen prior to the pandemic (which we believe is a conservative approach) for our forecast, we see that inflation is likely to remain above 3% through the first half of 2022 and above 2.5% through the third quarter. In other words, inflation is likely to move from the front pages to the back pages as we progress through 2022.

CPI YOY vs CMS inflation model
1998 – October 2022 (including forecast)

While consumers are worried that prices of certain goods will no longer be affordable, investors are looking for inflation protection for their portfolios, particularly within their fixed-income allocation. The issue is that what works in theory, may not work in practice.

Theory vs practice

When investing in bonds, an investor may be seeking protection from certain risks, such as market volatility or inflation. However, they’re still taking on other risks, such as liquidity, credit, or interest rate/duration risk.

Real return bonds are a type of government bond designed to protect investors from the effects of inflation. Both their face value and interest payments are pegged to the Consumer Price Index and adjusted twice a year, which means you’re able to maintain your purchasing power over the life of the bond. This is where theory and practice start to diverge. The vast majority of investors aren’t buying individual bonds and holding them to maturity. Rather, they’re likely invested in a fund or ETF that’s similar to the FTSE Canada Real Return Bond Index, which is a collection of bonds with many different maturities and yields; therefore, investors may not be fully benefitting from the inflation-protection nature of one specific security.

The risk assumed with investing in real return bonds is interest rate/duration risk, as these bonds have a fairly long duration. As of the end of October, the Real Return Bond Index had a duration of just under sixteen years. Bonds with longer durations tend to underperform when yields are rising. At times, they can perform well when inflation is moving meaningfully higher–2008 through 2011 (the coral line in the chart below), but in that period yields were also moving lower (the blue line). From November 2008 to December 2011, the FTSE Canada real Return Bond index returned 17.2% annualized. This was the reflation period following the great financial crisis but it wasn’t being priced into government bonds because of central bank intervention. Yields remained low and actually fell.

FTSE Canada Real Return Bond Index vs 10-year Government of Canada bond yield vs Canada CPI Index
2008 – 2011

However, typically when inflation is rising, we see a commensurate move in long bond yields like what we’ve witnessed in this present period, and RRBs underperform (the green line in the chart below). This underperformance can be attributed to the long duration makeup of RRBs. In the current environment, we’re seeing higher inflation but also higher yields, and as a result, underperformance of RRBs. From the beginning of this year to the end of October, inflation has risen from 0.7% year-over-year to 4.7%, and the 10-year Government of Canada bond yield has more than doubled from 0.675% to 1.721%. Yet the FTSE Canada Real Return Bond Index has been one of the worst performing bond indices, down 5.9%. RRBs only protect against inflation but not a rising rate environment. Rising rates will do more damage to the investment than the benefit of inflation protection.

FTSE Canada Real Return Bond Index vs 10-Year Government of Canada bond yield since 2019

When it comes to real return bonds, it seems that timing is everything and performance is more tied to yields than actual inflation. What you see isn’t always what you get.

Kevin Headland, CIM
Co-Chief Investment Strategist
Manulife Investment Management