Under the Hood: BMO Real Return Bond

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: BMO Real Return Bond Index ETF (ZRR)

The index: The fund tracks the DEX RRB Non Agency Bond Index, which consists of inflation-linked bonds issued by the Government of Canada. It seems to have been created specifically for this ETF.

The cost: The ETF’s management fee is 0.25%. As with other BMO funds, the actual MER will be higher because it includes GST/HST and some other expenses.

The details: This brand-new ETF (it started trading on Wednesday, May 26) holds five real-return bonds issued by the federal government, each making up about 16% to 23% of the fund’s assets.

Real-return bonds — or Treasury Inflation-Protected Securities (TIPS), as they’re called in the US — are an important asset class, and some financial experts recommend them as a core holding.

Both the principal and the interest payments of real-return bonds are tied to the Consumer Price Index, so they go up with inflation. Here’s an illustration of how this might work, courtesy of Bylo Selhi:

On a $1,000 bond, if the coupon interest rate is 3% and inflation is 1% after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3% by year end, the principal is adjusted to $1,030. You then receive another interest payment of $15.45. Assuming similar inflation over 10 years, you will receive $351.64 in interest payments while the principal will have risen to $1,343.92.

Real-return bonds typically have long durations: the maturity dates of the five in this ETF range from 2021 to 2041. Since real-return bonds were introduced in 1992, the average annual return has been 8.2%, which falls between that of short-term (6.6%) and long-term bonds (9.5%) over the same period.

The alternatives: Real-return bonds are an under-served asset class: until ZRR was launched, the iShares Real Return Bond Index Fund (XRB) was the only ETF of its kind in Canada. There are only two no-load mutual funds devoted to them — TD’s Real Return Bond Fund and Phillips Hager & North’s Inflation-Linked Bond Fund — and both are actively managed.

ZRR has undercut its iShares competitor in price — XRB charges 0.35% — although we’ll have to wait for the first Management Report of Fund Performance to learn what its all-in cost will be. TD’s mutual fund charges an onerous 1.42%; PH&N’s has a super-low fee of 0.53%, but brokers may require a minimum investment of $5,000.

What’s most interesting is that all of these funds have very similar holdings. The reason is simple: there just aren’t many real-return bonds to choose from. The federal government has just five issues, all of which are held by BMO’s fund. These five also also make up 86% of XRB, 60% of TD’s fund, and 80% of Phillips Hager & North’s. The only other significant issuers of real-return bonds are Ontario, Quebec and Manitoba, and provincial governments aren’t included in the index ZRR tracks.

The bottom line: It’s too early to pass judgment on ZRR: it will take at least a year to see if it’s able to keep its expenses down and track its index closely. But if it performs well, it will be an attractive alternative to iShares’ XRB, which currently holds over $594 million in assets. Given the extremely limited inventory of real-return bonds, performance of funds in this asset class really comes down to who can keep their costs lowest.

If you’re considering this new ETF, first look through the prospectus.

Disclosure: I do not own ZRR in my own portfolio. I have a small position in TD’s Real Return Bond Fund (too small to make an ETF cost-effective).

16 Responses to Under the Hood: BMO Real Return Bond

  1. DM May 31, 2010 at 9:03 am #

    Dan, I managed to get into the PH&N fund for $5000. I’m not sure their website says $25,000 minimum account size is required. My broker is iTrade. I’ve been very happy with the fund. Normally go with ETFs but in this case thought I’d give active management a try.

  2. Canadian Couch Potato May 31, 2010 at 9:19 am #

    DM: Thanks for pointing out the error. The $25K minimum is what’s listed on Morningstar. But in fact, it looks like you need $25K to open a self-managed account directly through PH&N, but you can buy each of their funds with less if you use a discount broker. I’ve changed the offending sentence.

  3. Patrick May 31, 2010 at 3:18 pm #

    XRB’s fees are too high, given the generally modest return to be expected from real-return bonds, so I’m quite interested to hear lower-fee alternatives.

  4. Maxwell May 31, 2010 at 7:09 pm #

    I am absolutely loving this “Under the Hood” series. One ETF that I would really like to see you analyze is Claymore’s Growth CorePortfolio (TSE: CBN).
    Please keep up the excellent work.

  5. Financial Cents June 1, 2010 at 11:57 am #

    Great series! Great detail in the post as well.

    Wondering if you would hold such an ETF unregistered or registered?

    I think you’d best to have at least $5 K to make the ETF purchase worth while. Otherwise, I like your route: TD Real Return Bond Fund.

  6. Greg TK September 26, 2011 at 4:14 pm #

    Dan — any thoughts a little more than a year after this post on using ZRR over XRB in a Complete Couch Potato portfolio?

    Looking to make the switch to an ETF based portfolio in the near future – thanks for all the advice!

  7. Canadian Couch Potato September 26, 2011 at 4:39 pm #

    @Greg TK: Just looked at the year-to-date performance (as of Aug 31), and it’s 7.68% for ZRR and 7.76% for XRB. Looking at 12-month performance, they’re again almost neck and neck, which shouldn’t be surprising, since their top holdings are the same.

    However, I have continued to recommend XRB in my model portfolios because its asset base is so much larger ($689 million v. $16 million) that I think it will likely be more liquid.

  8. Geoff Golding February 18, 2014 at 4:54 pm #

    Hi CCP – I’m a big fan and have been following your recommendations for the past five years. Wanted to see if there were any updates on your thoughts on XRB vs. ZRR? I see you’re still recommending the higher MER though more liquid XRB in your model portfolio.

    Thanks.

  9. Canadian Couch Potato February 18, 2014 at 5:06 pm #

    @Geoff: I think these two funds are equally good for real-return bonds. XRB has a bit more diversification in that it includes some provincials as well, but overall, but BMO’s has a slightly lower fee. Over the long term the difference in performance is likely to be very small. Over the three years ending Jan 31, ZRR returned 4.46% in market value and 4.84% on a NAV basis, while XRB was 4.42% on NAV basis (iShares doesn’t report market value returns).

  10. Que June 23, 2014 at 11:52 am #

    @Dan: Can you help explain the large difference between XRB & ZRR ‘s Weighted Average Yield to Maturity? Does XRB’s higher YTM out weigh ZRR’s lower MER, or am I missing something?
    Thanks, Que

  11. Canadian Couch Potato June 23, 2014 at 12:34 pm #

    @Que: It looks like iShares has started using the nominal YTM on their website. That wasn’t always the case. They used to use the real (inflation-adjusted) YTM, which is what BMO still appears to be doing. The yield to maturity on the BMO fund should be read as “inflation + 0.61%.” With a 2% inflation assumption that’s 2.61%, compared to the 2.81% iShares is using. The MER difference explains most of that difference. Slight variations in the portfolio likely explain the rest.

  12. Que June 23, 2014 at 3:53 pm #

    @Dan: Interesting, thanks for the feedback. How about the large (XRB is 10x ZRR) difference in distributions, is that just due to the value of the bonds when these funds purchased them, and if you hold either fund to maturity the values will balance out? Or am I missing something? Thanks again, Que

  13. Canadian Couch Potato June 23, 2014 at 8:59 pm #

    @Que: Where are you seeing the large difference in distributions? Both funds have a coupon slightly over 3% and a distribution yield of about 2%, give or take.

    Remember that the seven holdings in ZRR make up 85% of XRB. Any differences in the performance of these ETFs is going to be quite small.

  14. Que June 23, 2014 at 11:45 pm #

    @Dan: In regards to the large difference in distributions, I was comparing the upcoming June distribution, but I think I just realized the reason of the large difference, is that XRB pays out twice a year, where as ZRR pays out monthly.

    It is that exact reason that you point out (quoted below), which makes me wonder if XRB addition holdings is worth the extra MER, and makes me question why you would choose XRB over ZRR.

    “Remember that the seven holdings in ZRR make up 85% of XRB. Any differences in the performance of these ETFs is going to be quite small.”

    It just seems when you compare them, ZRR seems to be the better choice, Lower MER, Higher Coupon, and Higher YTM (you assumed 2%, although I found a site saying May 2014 was 2.3%). It would be nice to get a clear apples to apples comparison, so one could make an accurate choice. Unless you can point another reason you would choose XRB over ZRR?

    Thanks, Que

  15. Canadian Couch Potato June 24, 2014 at 9:05 am #

    @Que: I have no strong feelings about one over the other. I do like the added diversification of the provincial bonds in XRB and the much higher assets under management (ZRR was extremely small for a long time and is still only $33M), but I acknowledge the higher MER also. The difference it will make to your portfolio performance will be negligible.

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  1. Canadian Personal Finance Blog » Blog Archive » Random Thoughts: Did it Hurt? - June 4, 2010

    [...] Canadian Couch Potato writes an interesting overview in Under the Hood: BMO Real Return Bond I find this interesting because I didn’t even know this kind of investment vehicle existed. [...]

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