I’ve written before about how inflation can destroy wealth. Unfortunately, just saving is not enough to meet our future retirement needs. Money needs to grow and it needs to grow faster than inflation, otherwise you’re just in a losing race against time. Fortunately, there are many ways to protect against inflation without the need to invest in extremely risky investments. One of these vehicles is using the real return bond. Real return bonds provides an investment return that is fixed to the rate of inflation. The reason why the bonds are described as “real return” is because the interest rate reflects an amount that is adjusted for inflation. This means that if you are getting 2%, you are getting 2% in today’s dollars not 2% at the point in time when the bond was purchased. This sounds really confusing, but let’s get into a real life example.
Guaranteed Investment Certificates (commonly known as Certificate of Deposits in the US) are known to everyone. They are the typical investment instruments that major financial institutions pitch to you to park your money. The principal is guaranteed and you are given a fixed compounded interest rate for the period of your investment. The money remains locked in and so does the interest rate. The amount that is earned from year to year is easily calculated because it’s simply the interest multiplied by the principal.
For First Year
Interest Income = Principal x Interest Rate
In a simple example where $1000 is invested at 2%, the annual interest income would be $20. In the following year, the income earned would be compounded with the interest earned the first year and the principal invested.
For Second Year
Interest Income = (Principal + Interest Income From First Year) x Interest Rate
This means that in the second year the interest income would equate to $20.40. This would repeat for every subsequent year in the GIC that you would buy. In this sense you know that you are guaranteed 2% on the money that is saved and invested in a GIC.
Losing To Inflation
In the above example you are guaranteeing a 2% return, but what happens if inflation runs at 2.5%? Well the money that you invested after a year would come out to $1020, however, because of inflation what would have cost $1000 a year ago would now cost $1025. Since your investment only returned 2%, that $1020 actually buys less now than what the original $1000 would have bought. This is detrimental to your savings because the longer it sits in a GIC paying less than inflation, the less and less your money is worth. Despite the fact that you are saving, you are actually getting less out of your money than if you would have spent it right away. Of course this doesn’t make sense sometimes because you can’t buy food now and expect to not have it spoil by the time you need the money, but also remember that saving at a rate less than inflation means that you standard of living will decrease after you stop earning a regular income.
Real Rate of Returns
When making an investment choice it’s important to realize that you want to have positive growth after inflation. This income that is above the rate of inflation is what is classified as the real rate of return. You want that real rate of return to be positive not negative. Otherwise your investment strategy is a losing one. Real return bonds work in a way to give you that positive rate of return.
When a real return bond is bought, it’s bought at a specific face value. For our example let’s assume interest is paid at year end and that the bond is bought at an interest rate of 2% for $1000 and we have inflation of 2.5%.
For First Year
Interest Income = Principal x (1 + Inflation Rate) x Interest Rate
In order to account for inflation, the original principal is adjusted for inflation before calculating the interest rate payment. This means the $1000 is adjusted to $1025 and then the 2% interest is calculated giving an interest income of $20.50. At the end of the year, an investment of $1000 in a real return bond would be worth $1045.50 which represents a 4.55% gain but only a real gain of 2%.
For Second Year
Interest Income = (Principal + Interest Income From First Year) x (1 + Inflation Rate) x Interest Rate
In this example the principal and interest combined would be $1045.50. This would be adjusted for inflation becoming $1071.64. Therefore the interest income for the second year would be $21.43. In total the investment after 2 years would total $1093.07. This is significantly more than the $1040.40 that a GIC would be at after 2 years.
Consumer Price Index
The inflation rate that is used to adjust real return bonds is issued by Statistics Canada and it is commonly referred to as the Consumer Price Index. The CPI represents the cost of a basket of goods and services that a typical household would spend on. When a bond is priced, it is tied to a specific number in the CPI. Figuring out how much a bond should be adjusted is quite simply taking the current CPI and dividing out the CPI of when the bond was bought. This would give you the rate of inflation between now and when the bond was bought. An easier method for obtaining information regarding real return bonds and their rates is by visiting the Bank of Canada site and viewing their monthly issued reports.
In my contrived examples, I didn’t illustrate any notion of risk that buying real return bonds may actually contain. The fact is, real return bonds are subject to market forces no different than stocks, bonds and real estate. Despite the fact that the bond has a maturity date and a certain level of guarantee on the principal, it’s not expected that the price you pay for the bond will be the price you get back at maturity. Bond prices can be driven up, and thus interest rates lower, if there is a high demand for the bond. If you review my post on bonds, you’ll understand that is is possible to lose capital on the price of the bond depending on how much demand there is for it.
Additionally, real return bonds are sensitive to interest rate hikes from Central banks just like any other investments. If there are newer issues for bonds that give a higher yield, bonds that are paying a lower yield will have their value adjusted to reflect these new rates.
Do real return bonds belong in your portfolio? Perhaps. It all depends on the type of portfolio you’ve built and the risks you are willing to take. As an investment, real return bonds provide an inflation adjusted fixed income that will ensure that any sort of rapid inflation doesn’t destroy wealth that is just “sitting” in the bank. As part of a diversified portfolio, real return bonds can be part of the more conservative, fixed income portion of the portfolio.