Your Complete Guide to Index Investing with Dan Bortolotti

The Real Problem With Inflation-Protected Bonds

2018-05-29T21:44:26+00:00May 30th, 2016|Categories: Asset Classes, Bonds|Tags: |27 Comments

When I announced my stripped-down model portfolios at the beginning of last year, one of the asset classes I dropped was real-return bonds (RRBs). Part of the reason was simplicity: it’s easier to manage a portfolio of three or four funds compared with five or six, and you’re not giving up much diversification. But there was a more important reason for booting real-return bonds from my recommended portfolios.

First, a quick refresher. RRBs 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 guaranteed to maintain your purchasing power over the life of the bond. That feature overcomes one of the biggest shortcomings of traditional bonds.

There’s little question that RRBs are useful in theory. Consider a retiree who needs $50,000 annually to meet her expenses today. She could build a 10-year ladder of traditional bonds with a face value of $50,000 each, but by the time that last bond matures $50,000 won’t buy as much as it used to. Assuming 2% annual inflation, its purchasing power will erode to less than $41,000 in 10 years. If she builds a ladder of RRBs instead, the inflation adjustment would ensure the proceeds of each maturing bond will buy a similar amount of groceries, clothing and furniture every year.

Even if you’re a long way from retirement, real-return bonds are a useful diversifier. They have a generally negative correlation with equities—which means they tend to go up when stocks go down—and do not move in lockstep with traditional bonds. That means including a slice of real-return bonds can lower the overall volatility of your portfolio.

An issue of maturity

So with all of these positive characteristics, why did I remove RRBs from my model portfolios? Because the theory isn’t easy to put into practice in Canada.

In the US, real-return bonds are called Treasury Inflation-Protected Securities, or TIPS. They are issued regularly with five-, 10- and 30-year terms, and there is an active secondary market, which means you can buy them at all maturities relatively easily. Or if they prefer, US investors can use the iShares TIPS Bond ETF (TIP) or Vanguard Inflation-Protected Securities Fund (VIPSX) to buy a basket of about 40 issues with an average maturity of 8.7 years, roughly the same as a traditional broad-market bond index fund. Americans can even buy inflation-protected I Bonds directly from the US Treasury, similar to our Canada Savings Bond program.

In Canada, the market for real-return bonds is far more limited. The feds started issuing real-return bonds in 1991, the same year the Bank of Canada set an inflation target of 1% to 3%. But they are generally issued with 30-year maturities, and in much smaller volume. The provinces of Ontario, Manitoba and Quebec have also issued some RRBs, but the overall pickings are slim in this country.

As a result of the limited choice, virtually all Canadian real-return bond funds are highly concentrated in just seven issues, and the average maturity is more than double that of their US counterparts, at just under 20 years.

Here’s a glimpse of the main holdings of the only two ETFs in this asset class—the iShares Canadian Real Return Bond Index ETF (XRB) and the BMO Real Return Bond (ZRR)—along with the actively managed TD Real Return Bond Fund and the PH&N Inflation-Linked Bond Fund:

Bond issue, coupon and maturity Term (years) XRB ZRR TD PH&N
Gov’t of Canada 4% – Dec 2031 15.5 15.4% 17.3% 12.7% 4.9%
Gov’t of Canada 4.25% – Dec 2026 10.5 13.5% 15.2% 6.1% 14.6%
Gov’t of Canada 3% – Dec 2036 20.5 13.3% 14.6% 10.3% 23.4%
Gov’t of Canada 1.5% – Dec 2044 28.5 13.2% 14.9% 15.0% 17.8%
Gov’t of Canada 2% – Dec 2041 25.5 12.5% 14.1% 6.0% 12.5%
Gov’t of Canada 4.25% – Dec 2021 5.5 12.0% 13.3% 8.4% 13.2%
Gov’t of Canada 1.25% – Dec 2047 31.5 8.4% 9.7% 11.9%
Total % of fund’s net asset value 88.3% 99.1% 70.3% 86.4%
Sources: BlackRock, BMO, TD Asset Management, Phillips Hager & North. ETF holdings as of May 26; mutual fund holdings as of April 30.


A roller coaster ride

The long maturities and low coupons of RRBs in Canada give them a very long duration—just under 16 years for the BMO and iShares ETFs. This means they are extremely sensitive to changes in interest rates: even a modest move can cause the value of these funds to rise or fall by double digits. Have a look at the returns of XRB for the six calendar years before I removed them from my portfolios:

Year Return
2009 14.13%
2010 10.64%
2011 17.87%
2012 2.43%
2013 -13.43%
2014 12.68%
Source: BlackRock


That’s a nice annualized return of 6.84%, but at the cost of huge volatility—and so we arrive at the main reason I removed real-return bonds from my model portfolios. It’s really about behaviour. In my experience, investors generally accept that equities are volatile, and they are willing to endure big swings because they know they can expect meaningful returns over the long term. But most find it difficult to tolerate that level volatility in their fixed income, which is after all supposed to be the stable part of a portfolio. With real yields close to zero these days, the combination of low expected returns and massive volatility is not compelling.

Even if RRBs can lower the overall volatility in a portfolio, it’s easy for many investors to lose sight of the big picture and to focus on this one asset class in isolation. When they do that, they tend to make poor decisions, like selling low or refusing to rebalance.

If you understand the risks of real-return bonds and are willing to accept their high volatility, they might still be a worthy addition to a diversified portfolio, though I would recommend they make up no more than a quarter of your fixed income holdings. Most Canadians, however, are likely to find a smoother ride with more traditional holdings. That’s why I recommend a plain old broad-based bond index fund for most investors, particularly those who are still growing their portfolios. If you’re in or approaching retirement—or if you simply prefer low volatility—then use a short-term bond fund and perhaps a ladder of GICs.



  1. Willy May 30, 2016 at 10:38 am

    Thanks for another great post. I use XRB today, 10% similar to the original Complete Couch Potato. I was aware that the offerings were limited in Canada, and I’m sure I have read the fund page at least a couple times, but it’s good to see the concentration risk highlighted directly in a table like that. It was a good reminder for me / I probably was not appreciating the magnitude of the concentration before.

    I’ll likely stick to my 10% allocation for now in light of the positives mentioned (low correlation) and because I believe some of the behavioral negatives don’t fit me (I don’t sweat the return of individual securities, just the portfolio as a whole, and am not likely to be bothered by the volatility in this small part). I’ve committed not to tinker with allocations, absent some really compelling reason.

  2. Canadian Couch Potato May 30, 2016 at 11:13 am

    @Willy: Thanks for the comment. I should clarify about the concentration, because I don’t want to suggest this is very risky: let’s remember that whether you hold seven Government of Canada bonds or 700 Government of Canada bonds, your credit risk is essentially the same, since it is all one issuer. The problem here is more about the small number of bonds resulting in very little flexibility when it comes to building a portfolio. Unlike with a portfolio of traditional bonds, you can’t really adjust the duration or build a ladder, etc. It’s like trying to build a LEGO figure when all your blocks are large and square: you’re pretty limited in what you can do.

  3. Adam C May 30, 2016 at 12:21 pm

    Do you think your comments about these bonds’ returns being like a “roller coaster ride” apply in the same way to longer maturity vanilla government bonds as well?

    I’m relatively young and have almost my entire 40% fixed income allocation in short term corporates (VSC). My thinking is that the fixed income piece should be low volatility, and with rates so low, long term bond prices are very sensitive to small changes in rates. Once rates normalize (say, the 10 year benchmark bond yields 4%), I’m comfortable moving to a fund with an average duration closer to ~10 years as you recommend.

  4. Michel Lafontaine May 30, 2016 at 12:40 pm

    I have in my RIF portfolio a “stripped coupon” Government of Canada RR Bond that matures in June 2018. I have only this one for now (I bought it way back in 2005) but isn’t this a proper way to solve the maturity problem that you describe?

  5. Canadian Couch Potato May 30, 2016 at 1:22 pm

    @Adam: Yes, the high volatility of long-term bonds applies to traditional bonds as well as RRBs. That’s the main reason I wouldn’t recommend using a long-term bond fund even for a portfolio with a time horizon of decades. Just be careful when you assume you’ll change your strategy when rates “normalize.” No one knows how long it will take for 10-year bonds to get back to 4%!

    @Michel: Probably, yes. By stripping the coupons from a 30-year bond you can create a series of shorter “bonds” with various maturities. I’m not sure how easy it is to find this inventory, but a good fixed income desk can probably build a ladder of these.

  6. Adam C May 30, 2016 at 1:56 pm

    @CCP: I get what you’re saying – I realize there’s an element of market timing and for sure it’s something to think about. However, I think the steepness of the yield curve should inform fixed income asset allocation decisions and to me, it’s not steep enough to be worth the extra interest rate risk.

    The worst case scenario is that I keep the short term stuff perpetually. In that case I may be missing out on slightly higher fixed income returns, but I should have lower overall risk/volatility.

    It has been 2.5 years now I’ve invested this way and it has been a poor decision so far. That has lost me almost 1% annualized per year (on the fixed income portion of my allocation) versus holding VAB. I’m willing to admit that and simply wait as long as it takes for longer term bonds to become cheaper. Time will tell if that turns out to be a bad idea or a good one, but I’m fine with either outcome and am just trying to make the most prudent decision with the information available.

  7. 05/30/16 – Monday’s Interest-ing Reads | Compound Interest-ing! May 30, 2016 at 3:05 pm

    […] The real problem with inflation-protected bonds. (canadiancouchpotato) […]

  8. Tristan May 30, 2016 at 3:28 pm

    @CCP: I like the idea of inflation linked bonds, but don’t own any because, nearing retirement, I don’t want to deal with the added complexity of dealing with long duration bonds funds, particularly when it comes to mandatory withdrawals from my RRSP. If there were short and intermediate term real return bonds funds available in Canada, as in the US, I probably would hold them.

  9. Le Barbu May 31, 2016 at 10:16 am

    I wonder wich low cost ETF can be used in my TFSA to “match” ZCN

    I dont mind about volatility, as long as it doesnt move exactly the same way as ZCN does to help rebalance once in a while if needed. Bonds ETFs like VAB and VSB would be nice if only they got better expected returns. ZRE have higher expected returns but also higher MER and is sensible to interests rates rise. I dont hold any other canadian asset rigth now and I am still thinking what would be a sound choice. Now, I dont know if XRB would fit this purpose…

    For the record, my big picture looks like this: 33%ZCN (TFSA, RESP, taxable account), 24%VTI-19%VBR-25%VXUS (RRSP). I would like my exposure to ZCN to be closer to 30% and because of the TFSA and RESP, it’s getting more difficult to achieve.

    Another alternative would be to hold some US and other Int’l in my TFSA (or just good old cash)…

  10. Matt June 1, 2016 at 10:23 am

    Is there an expectation that as time passes there will be more options for RRBs and the decrease in average maturity of the existing issues will reduce the volatility of RRB ETFs?

    Would such a volatility reduction then result in the re-inclusion of RRBs in the recommended portfolios in the future?

  11. Solanum tuberosum June 1, 2016 at 12:24 pm

    Excellent article.

  12. Canadian Couch Potato June 2, 2016 at 7:46 am

    @Matt: I have seen nothing to indicate that Canada plans to increase the variety of RRBs it issues. The CD Howe Institute issues a report a few years ago recommending this, but as far as I know they are all still 30-year bonds.

  13. Harry Beach June 2, 2016 at 6:32 pm

    I wonder why a Canadian investor couldn’t use the US TIPS etfs?

  14. Canadian Couch Potato June 3, 2016 at 3:06 pm

    @Harry: The main reason is that US bonds introduce currency risk into the portfolio, which means even more volatility:

    Even if there were a way to get rid of the currency risk, TIPS are pegged to US inflation, so they would not provide the same protection to an investor whose expenses where in Canadian dollars.

  15. Erik June 4, 2016 at 1:28 pm

    Thanks for the article Dan. Interesting to know about the term differences in RRBs in Canada versus the US.

    From my reading of Larry Swedroe, he finds that term risk (along with credit risk) doesn’t result in a compelling premium.

    “Interestingly, there hasn’t been much debate about the default and term premiums in bonds. Yet investors have historically received very little in the way of compensation for taking default risk, and not much of a premium for taking term risk once you get beyond the intermediate term.”

  16. Canadian Couch Potato June 4, 2016 at 1:53 pm

    @Erik: I tend to agree with Swedroe. That’s why I think a good default choice for bonds is intermediate terms (average about 10 years, as in a broad-based index fund) and high-quality only, i.e. no high-yield bonds.

  17. Tristan June 6, 2016 at 8:44 pm

    @Eric: Although as Larry Swedroe points out in this article, there is not as much risk (volatility) to get the term premium with long term TIPS as with nominal bonds, as TIPS are less sensitive to changes in nominal interest rates. Also because TIPS fully hedge inflation you can extend maturities and earn the term premium without taking inflation risk.

  18. Peter June 7, 2016 at 1:54 am

    Never heard of this until now.

    Thanks for bringing it to my attention

  19. Rudy SMT June 10, 2016 at 8:04 am

    Hi Dan, I love your articles and thanks for sharing.

    I would add something about investing oversee and currency risks. All currencies are FIAt and are linked to the US dollars.

    Any currency has a lifecycle of about 9-18 years.

    That means if you start to invest today for the next 30 years, the currency will rematch today exchange at some point in the future, so the currency risk gets neutralize, at least for the first phase of the currency cycle.

    Maybe is too complicated for the average investors.

  20. Erik June 10, 2016 at 3:20 pm

    @ Tristan.

    Thanks. That’s a helpful distinction between higher term regular bonds and RRB.


    That’s a good point. PHN had a recent post highlighting that over 20 years the difference in returns would be almost nil.

    Older investors may have more or their portfolio in Canadian fixed income, which, along with their Canadian equity component, would reduce their currency volatility, assuming a 20-30 year retirement.

  21. Rudy SMT June 10, 2016 at 9:20 pm

    Hey Erik,

    Thanks for sharing, great article. I love technical charts.

    I love the natural hedge with a portfolio of different currencies, in fact in 2013 I start to move away from South East Asia currencies (I was paid in these currencies while working in Malaysia and Thailand) to US Dollars after Bernake announced the end of QE.

    Today, I can see my portfolio beeing less shaky when any currency dips being the US dollar, Thai Baht or Malaysian Ringgit.

    I feel my portfolio is stronger in different currencies and allow for extra returns by following the weaker currency.

    For example, now I’m analyzing to move into Pound Sterling after the currency touched the lowest reading against the US dollar for the last 30 years.

    I might buy bonds denominated in GBP.

    The risk/opportunity is favorable in the long term of a strengthen of the Pound Sterling against the US Dollar. When others see risks in currencies, I see opportunities.

    For the Canadian investors, there aren’t much of opportunities at the moment for oversea investments, considering the currency is in a status quo.

    The last time the Canadian investors had a window opportunity to invest oversee “safely” from the currency shakes was in 2004. However, because currencies are cyclical, the Canadian dollar will enter in another favorable window in the next 15 years.

    There is much more about cyclical currencies that a post would be more appropriate than a comment.

  22. Jane August 12, 2016 at 12:21 pm

    Currently I have planned 5% in inflation-protected bonds. After rebalancing I have extra cash in US dollar RSP – because I need fixed income as I have just retired …. my choices seem to be US Tips ETF or US bond ETF. If I knew how to buy bonds demoninated in GBP I would research that option. Thoughts??

  23. Canadian Couch Potato August 12, 2016 at 12:30 pm

    @Jane: It’s not clear to me why you want to buy foreign-denominated bonds. This not normally something I would recommend, as it exposes you to currency risk on the fixed-income side of the portfolio:

  24. Peter October 11, 2016 at 7:44 pm

    So when would a short term bond fund like VSB be used versus a longer term ETF.

  25. John November 28, 2016 at 1:13 pm

    What do you think of including MIC’s in the fixed income portion of a diversified portfolio….given the likely anemic return of bonds in the foreseeable future?

  26. Canadian Couch Potato November 30, 2016 at 1:11 pm

    @John: There is no way (that I’m aware of) to invest in a diversified, passively managed portfolio of MICs. Even if there were, higher yields on fixed income investment always come with additional risks. That doesn’t necessarily mean they are a bad investment, only that there is always a trade-off.

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