Real Return Bonds (RRB’s) are bonds that are issued by the Government of Canada and certain provinces. They are issued with a fixed coupon rate, pay semi-annual interest and have a specified maturity date just like regular bonds. The difference is that they pay a rate of return that is adjusted for inflation (changes in the Consumer Price Index-CPI) so you are assured that your purchasing power is maintained regardless of the future rate of inflation.
Real Return Bonds pay a semi-annual interest based on an inflation adjusted principal, and at maturity they repay the principal in inflation adjusted dollars.
How Do They Work?
The coupon rated rate remains fixed. What changes is the principal. For example, assume a RRB of $10,000 paying a coupon rate of 3%. If the CPI rises 1% in the first six months, the principal would be adjusted to $10,100 and the coupon payment would be $151.50 (half of the annual 3% interest).
Six months later, if the CPI goes up by another 2% the principal now becomes $10,302 and the interest payment would be $154.53, and so on.
The inflation-adjusted principal amount accrues and is paid out at maturity.
Benefits of Real Return Bonds
- Predefined real return
- Less volatile than regular bonds
- Returns correlated to inflation
- Purchasing power protection
- Guaranteed by the Government of Canada
Risks Associated With Real Return Bonds
- Typically have long maturities (up to 2044)
- Low current yields (average 1.79%)
- Can be hit with a hefty capital loss if sold before maturity and interest rates have risen
- If the inflation rate drops you will receive less interest income and possibly a reduced principal at maturity
How Are They Taxed?
Interest is taxed as ordinary income at the highest marginal tax rate. The inflation adjustments to the principal are taxed as they accrue even though you won’t receive them until the bond matures. Therefore, they are best held inside a tax-sheltered account.
Purchasing Real Return Bonds
Investors can buy individual bonds from their broker. Alternatively you can purchase RRB Mutual Funds, but with MERs of around 1.5%, a third or more of the return will be eaten up by fund expenses. TD Real Return Bond fund was the first Canadian RRB fund and has an MER of 1.46%.
ETF’s have more modest MERs. iShares DEX RRB Index ETF (XRB) has an MER of 0.35%. BMO RRB Index ETF (ZRR) has an MER of 0.25%.
Real return bonds are mainly a buy-and-hold investment. They are best purchased when inflation is expected to rise. They can complement a 5-year bond ladder and offer stability to investment returns.
