Do inflation-linked bonds make sense in an era of rising interest rates?

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The risks and rewards of investing in TIPS, RRBs and the ETFs that hold them.

Do inflation-linked bonds make sense in an era of rising interest rates?

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For a long time, inflation-linked bonds like TIPs (Treasury Inflation-Protected Securities) in the U.S. or Government of Canada Real Return Bonds (RRBs) seemed like valid alternatives to nominal bonds for inflationary environments. If inflation ticks above certain levels, such bonds—or exchange-traded funds (ETFs) that hold them—tack on extra interest payments twice yearly, commensurate with the rise in the official inflation rate.

Matthew Ardrey, a wealth advisor with Toronto-based TriDelta Financial, says that while inflation’s average 2% annual rate over the last 20 years has been considered “benign,” it’s still 40 basis points higher than the average Bank of Canada overnight rate during that period. “It has been eroding risk-free returns for a long time.”

Prevailing interest rates have been less responsive to inflation dynamics in that time frame, Ardrey adds. “Central banks have communicated a tolerance for higher inflation rates in order to foster growth.”

Duration risk and inflation-linked bonds

TIPS were designed for the U.S. government with assistance from billionaire Ray Dalio, founder of Bridgewater Associates, as noted in my previous Retired Money column. He has long argued that true balanced portfolios go beyond the usual 60/40 mix of stocks and bonds to include TIPS (or RRBs, in Canada) and gold/commodities.

Given that inflation was benign until mid-2021, I’m guessing most Canadian investors are underweight the last two asset classes and are probably overweight stocks. But now that inflation has started to roar, many must be agonizing over what to do about it.

Since inflation puts pressure on rates to rise, what happens if the longer-term bonds held in funds inflict capital losses when rates spike at the same time? That’s the problem with both TIPS and Canadian RRB ETFs that hold too much in long- or mid-term bonds—and most of them do. Then price volatility from duration risk may outweigh the inflation-protection benefits, according to an analysis by BMO Wealth Management of the perils of holding TIPS during times of rising rates.

Last year wasn’t a good one for fixed income funds in general, although by Dec. 31, 2021, the iShares Canadian Real Return Bond Index ETF (XRB) and the BMO Real Return Bond Index ETF (ZRR) both had slightly positive returns for the year: 1.43% for XRB and 1.26% for ZRR. But if rates rise multiple times in 2022, then what?

This may be less of a problem if you hold RRBs directly and until maturity: Government of Canada Real Return Bonds issued by Ottawa have maturities ranging from five years out to 30 and even 40 years out. I used to own some of these directly, but they matured in December 2021.

When I tried to find a new series at RBC Direct Investing, none seemed to be available online. However, you can buy newer issues by calling the bond desk. The two with the shortest maturities were one with a 4.25% coupon and a maturity date of Dec. 1, 2026, priced at $127.28, and another with a 4% coupon and a maturity date of Dec. 1, 2031, priced at $146.55. Note that the BMO paper says that unlike TIPS, RRBs have no protection against deflation.

TriDelta’s Ardrey agrees the horizon of an inflation-linked bond is important: “Linking its return to the realized inflation rate can benefit investors, but the value of the bond in the market also relies on the expected inflation rate over the life of the bond (called the breakeven.)”

Ardrey notes the current inflation rate in Canada is 5.7%, so an RRB investor would periodically receive that inflation adjustment in the value of the bond. “However, the market is pricing in average expected inflation at 2.12% through the 2026-maturity RRB. If, say, the market believes the economy is slowing or that the imminent rate hikes will successfully quell inflation, then the market could price expected inflation lower, resulting in price depreciation of the bond, partially or entirely offsetting the near-term inflation compensation the investor receives.”

Inflation-linked bond ETFs to consider

If you want to diversify through funds, minimize interest rate risk and get inflation-linked bond protection, Canadians have more flexibility via U.S.-traded TIPS ETFs, like the Vanguard Short-term Inflation-Protected Securities ETF (VTIP), which holds short-term bonds maturing in under five years. It has a low MER of 0.05% and average duration of just 2.7 years. Describing the ETF as “low risk,” Vanguard says: “Given its shorter duration, the fund can be expected to have less real interest rate risk, but also lower total returns relative to a longer-duration TIPS fund.”

VTIP largely gets around the problem of interest rate risk, but it also introduces currency risk for Canadian investors. Some Canadian ETF makers are addressing this problem. In 2018, Mackenzie Investments launched its Mackenzie US TIPS Index ETF (CAD-Hedged), trading under the memorable ticker symbol QTIP. However, only 16.7% of the bonds mature in the next two to three years—10.3% mature in under two years, 22.2% in three to five years, 18.4% in five to seven, 12.3% in seven to 10, 4.3% in 10 to 20, and 15.1% in 20 or more years (as of Jan. 31, 2022).

Fortunately, two newer TSX-listed bond TIPS ETFs get around the issue of too many long-dated bonds by holding mostly short-term U.S. TIPS hedged

Fortunately, three newer TSX-listed bond TIPS ETFs get around the issue of too many long-dated bonds by holding mostly short-term U.S. TIPS hedged back to the Canadian dollar:

  • The iShares 0-5 Year TIPS Bond Index ETF (CAD-Hedged), ticker XSTH, was launched in July 2021.
  • The BMO Short-Term US TIPS Index ETF, ticker ZTIP.F, was launched in January 2021. Its weighted average duration is just 2.52, compared to XRB’s much more volatile 15.1.
  • The CI U.S. Treasury Inflation-Linked Bond Index ETF (CAD-Hedged), launched in August 2021 under the ticker CTIP, is similar to ZTIP.F.

In my case, I reinvested the proceeds of the matured Government of Canada RRBs into a combination of the 2026 series and ZTIP.F. Both are marginally under water. A few years from now, once rates have come off the bottom and level off, the time may come for longer-term RRB funds like XRB and ZRR.  

Benjamin Felix, a portfolio manager at PWL Capital, says inflation-protected bond funds are “only an obvious hedge against unexpected inflation if the bond matches your investment horizon.” Say you have a $100,000 expense in 20 years. If you buy an inflation-protected bond maturing in 20 years, you are guaranteed to maintain your purchasing power plus the real yield on the bond by the end of the 20-year period.

Short-dated inflation-protected bonds get around the issue of bond price volatility, Felix says, but introduce a new problem: At current levels of expected inflation, they have lower real yields than short-dated nominal bonds, which already have low yields. They will pay off if inflation increases unexpectedly, but nobody knows where inflation is going.

Is short-term fixed income a hedge against inflation?

Felix makes the surprising observation that short-term fixed income and cash are an often-overlooked inflation hedge. “It seems like cash would be the worst thing to hold during a period of high inflation, but that is only true for dollar bills sitting under your mattress,” he says. “Short-term debt and cash earn interest. If central banks raise rates to combat inflation, as they tend to do, interest rates on short-term debt will also increase. Rising rates hurt the prices of longer-maturity bonds badly, but short-maturity fixed income, like one-month Treasury bills or cash, is relatively unaffected in price while it quickly benefits from rising yields.”

Between 1966 and 1982, inflation ravaged stock returns, while one-month U.S. Treasury bills outpaced inflation by a narrow margin, Felix says. However, “they maintained purchasing power. Even over long periods of time, bills, short-term government debt, have been able to at least keep pace with inflation in Canada, the U.S., and most other countries around the world. It is possible in some situations that short-term rates will not rise with inflation, so, again, they are not a perfect hedge.”

Adrian Mastracci, a portfolio manager with Lycos Asset Management in Vancouver, suggests investors need to take the time to do the homework on this asset class: “It is an unforgiving area for those who are uncertain about the concepts.”

MoneySense Investing Editor at Large Jonathan Chevreau is also founder of the Financial Independence Hub, author of Findependence Day and co-author of Victory Lap Retirement. He can be reached at [email protected].

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