What are real return bonds?

A $1,000 bond is issued with a 3% “real” interest rate.
In the first 6 months, inflation rises 1%.

• Principal is adjusted to $1,010 = [$1,000 multiplied by 1.01%]
• Semi-annual interest payment is $15.15 = [3% divided by 2 multiplied by $1,010]

• Principal is adjusted to $1,030.20 = [$1,010 multiplied by 1.02%]
• Semi-annual interest payment is $15.45 = [3% divided by 2 multiplied by $1,030.20]

Guaranteed inflation protection

Both the principal and interest will keep pace with inflation over the term of the investment. High levels of inflation will not erode your buying power and your bond will have the same buying power at maturity as it did when you bought it.

Security

Both the principal and interest of RRBs are fully guaranteed by the Government of Canada, with no maximum.

Diversification

RRBs have characteristics similar to the commodities asset class which, unlike most other asset classes, tends to gain in value when inflation rises. However, unlike most commodities, the holder of the RRB is paid to hold the asset.

Reduced reinvestment risk

Inflation compensation on principal accrues daily but is not paid out until maturity. So, the nominal value of the principal compounds at the rate of inflation.

Cash flow variability 

Although the real coupon is known, the nominal yield depends on inflation throughout the term of the bond. As a result, the actual semi-annual interest received will vary at each payment date. This means RRBs will have less appeal if you require fixed semi-annual interest payments.

Price volatility

RRBs are subject to fluctuations in market price due to changes in real yields and fluctuations in the CPI. Since longer-term bonds take a long time to mature and have greater price fluctuations, you need to be reasonably certain that you can hold your bond for the long term. Like nominal fixed-coupon marketable bonds, if you sell an RRB before maturity, the price you receive will be based on the current interest rate and could be more or less than what you originally paid.

Liquidity

There are presently 8 issues outstanding, maturing in 2021, 2026, 2031, 2036, 2041, 2044, 2047 and 2050. The total amount outstanding is still small compared with other Government of Canada bond issues. An RRB mutual fund may provide for more liquidity and diversification.

Index risk and lag

The inflation calculation is specific to the all-in-one, seasonally adjusted CPI. There are numerous, and more broadly based, measures of inflation than this one index. It is possible that the narrower measure used does not fully protect you from price gains on the goods and services you actually buy. In addition, the actual inflation calculation uses a lag of about 3 months. This may affect the integrity of the trading price, and you may see bond price volatility, especially during periods of rapid changes in the CPI.

• Interest payments are taxed as ordinary income. Inflation compensation, if any, is taxed annually as interest while it accrues, even though it isn’t paid out until maturity. In case inflation increases, any additional amounts included in the interest income will be added to the adjusted cost base (ACB) of the bond. On the other hand, a decrease in inflation will result in a deduction from income and, at the same time, will be deducted from the ACB of the bond.
• The inflation compensation will affect taxes paid on non-registered accounts upon the disposition or deemed disposition of the bond.
• RRBs may be suited for registered accounts, where interest and the inflation compensation will not be subject to tax until withdrawn from the plan.

• Issuer: Fully guaranteed by the Government of Canada
• Term to maturity: 8 issues only
• Minimum investment: $5,000 face value, in multiples of $1,000
• Currency: Canadian Dollars
• Income payments: Interest paid semi-annually based on inflation-adjusted principal; at maturity, principal repaid with inflation-adjusted dollars