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Defending Against Rising Inflation and Interest Rates
April 5, 2006Download or View related file in .pdf format >>
We have entered the stage of the economic cycle where both the rate of inflation and interest rates have begun to rise. This means falling bond prices and the longer the term of the bonds, the further their price will fall. Investors are asking how to protect themselves in this environment. There are two basic approaches for investors to follow:
Each of these approaches, or some combination of the two, should help in defending investors' portfolios while producing acceptable returns. Real Return Bonds are indexed to the Consumer Price Index and thus offer "real" returns. The Laddered Portfolio Strategy involves putting together a portfolio of conventional bonds with the maturities equally staggered so that there is a steady stream of maturing bonds to reinvest as rates move higher. The risk at this stage of the cycle is to reach for extra yield in longer term maturities where the greatest risk is to principal. The Laddered Approach avoids this trap. Both of these approaches are suitable for both taxable and sheltered accounts.
Real Return Bonds
Inflation is the enemy of bonds. At an inflation rate of approximately 5%, a dollar's purchasing power shrinks to just 61 cents in only 10 years! Since most fixed income instruments pay a fixed rate of interest, inflation will erode the purchasing power of those payments over time. Investors, cognizant of this fact, expect to earn a real return (yield minus inflation) of approximately 2% before taxes on government bonds.
The question then becomes which inflation rate to use to compute a real return? The past twelve months, the average for the past five years, or the inflation expectations for the next one or several years? It appears that the expected future rate of inflation is the key variable.
There exists a fixed income instrument which guarantees real returns and which also serves as a useful proxy for inflation expectations. This is the real return bond (RRB).
What are Real Return Bonds?
Characteristics of Real Return Bonds(RRBs):
At the time of writing, there are four issues outstanding:
Note that they are issued with a nominal coupon rate which reflected the inflationary expectations at the time that they were issued. Thus, as inflationary expectations wax and wane, the price of these bonds will rise and fall accordingly.
Who buys them?
Pension funds, particularly non-profit ones such as municipal or provincial plans, are the most common buyers, as RRBs are very useful for meeting or exceeding actuarial assumptions.
While their complexity makes these bonds somewhat daunting for individual investors, there is growing demand from individuals for the inflation protection that they offer.
While not as liquid as other Canada bonds, there is a decent market nonetheless. RRBs are primarily buy-and-hold investments, offering investors a real return that will be realized as long as they hold them to maturity or if they could sell them for the same yield as they bought them.
This is not to say that they do not have significant price swings. Their price fluctuations arise from shifting inflation expectations. Figure 1 in the downloadable pdf is a chart showing the changing yield over time:
Figure 1 shows what is called the Break Even Inflation Rate (BEIR). In other words, by subtracting the yield on the RRBs from a long term Canada bond (In this case, we are using the Canada 5.75% June 1, 2029 and the Canada 4% December 1, 2031) we arrive at where the two yields imply the real yield to be.
As can be seen the BEIR has risen steadily to just over 3% while the RRB yield has fallen to the 2.20% area. This implies that either RRBs are expensive and that their yield should rise or that conventional bonds are relatively inexpensive or some combination of the two.
In this environment, with inflation expectations beginning to firm up, it appears that RRBs are expensive compared to conventional bonds. This only matters if investors would ever contemplate selling their RRBs. If they buy them at a 2.20% real return, that is what they will receive if they hold them to maturity. However, if real yields rise, the price of the RRBs will fall.
Figure 2 is a price chart of the Canada RRB 4% December 1,2031. The purpose of showing this chart is to make sure that investors realize that these bonds can have dramatic price changes:
As can be seen, these RRBs have risen some 30 points since 1999 and investors have experienced positive rates of return. The purpose of showing this chart is to point out that these securities have considerable price volatility which can adversely (or positively) affect total returns.
As indicated, if held to maturity, the real yield will be maintained. As a theoretical example only, should real yields rise to 3% from 2.2%, these bonds would fall in price by 18 points!
In summary, Real Return Bonds offer indexed protection against inflation although they fluctuate in price depending on the level of inflation expectations. They may be easily purchased in quantities suitable for individual investors. The actual indexation and taxation issues are too complex to be included here. For a complete analysis of RRBs, we refer you to the attached PDF file from the Bank of Canada's website. http://www.bankofcanada.ca/en/pdf/real_return_eng.pdf
The Laddered Portfolio Approach
Part two of our recommended strategy for defending against rising inflation and interest rates is to employ the time-tested, successful Laddered Portfolio approach. It is simple and offers attractive returns over time.
Investors purchase individual bonds, (or strip bonds for RRSPs) of regularly spaced maturities. As an example, individuals with $100,000 could invest $10,000 in annual maturities ranging from one to ten years. After the first one year bond matures, they would then reinvest in another ten year bond to keep the ladder intact. Specific examples follow.
The prime purpose and advantage of this approach for investors is to avoid the trap of putting all their money in one maturity at the wrong time. They thus avoid the trap, common at this stage of the interest rate cycle, of investing all their funds in the longest maturities at the highest yields.
What happens next, typically, is that interest rates rise at all maturities and bond prices fall. These yield hungry investors experience capital losses and have no funds available to reinvest at the higher yields.
The laddered approach has also outperformed two thirds of fixed income mutual bond funds over time as there are no annual Management Expense Ratio fees and the portfolio is not actively managed, avoiding the pitfalls associated with figuring out the direction of interest rates. No one has ever been accurate all the time in forecasting interest rate changes and this laddered approach removes the guesswork.
Here are two sample one to ten year ladders. Figure 3 is for taxable accounts while Figure 4 is best suited for RRSPs:
In Figures 3 and 4 , investors can purchase $130,000 of par or future value for slightly more than $100,000. When the $13,000 British Columbia coupon matures on September 2005, the proceeds are then invested in a 2015 maturity. Using today's yields for example, the ladder would now look like Figure 3:
Thus, as time goes on, the future value will continue to grow. The discipline of investing in this fashion prevents investors from guessing about interest rates or from putting all their money into a single maturity. If and when interest rates rise, the investors in ladders will always have maturing amounts to reinvest at higher yields.
Over time, then, the average yield of the laddered portfolio will fluctuate commensurate with the trend in inflation and in interest rates. The above examples are just that. Ladders are totally customizable: They can be for shorter or longer terms, can produce monthly income, can be all Government of Canadas for safety, and so on.
Summary And Conclusion
Both Real Return Bonds(RRBS) and Laddered portfolios defend against rising inflation. RRBS are complex securities and have market risk that is not commonly recognized. They do offer real returns if held until maturity.
Laddered portfolios are simpler with enhanced flexibility and little market risk and they are the preferred way for investors to achieve real returns. The Fixed Income Department offers RRBs at competitive prices and will create customized laddered portfolios on request.
You can also read more about this here at www.bankofcanada.ca/en/pdf/real_return_eng.pdf