Reality of Real Return

In the past 20 years interest rates have fallen and fixed income investors have done well. We are faced with record low interest rates and most economists would agree that the outlook for interest rates is higher. This will have a negative impact on your bond portfolio. The questions are, when will governments raise interest rates and how should you manage your fixed income portfolio in rising interest rate environment? I would say you have a number of choices, however, your approach should be flexible and active. Over the next few weeks I will explore some fixed income choices in a series looking at investing in a rising interest rate environment.

The objectives of iShares CDN Real Return Bond Index Fund (XRB) are to provide income by replicating the performance of the DEX Real Return Bond Index which is a market capitalization index of mostly Canadian federal and provincial real return bonds. It has 13 holdings with a weighted average term of 21.07 years, a coupon of 3.57%, a weighted average yield to maturity and a weighted average duration of 15.77 years. Duration is a measure used to identify the impact that a rise in interest rates would have on the price of a bond or pool of bonds. So for example, with duration of 15.77, a 1% increase would mean a price decline of 15.77%.

Over the last year the XRB has risen in price from a low of about $18 in March 2009 to a recent high of about $20.75 in late January/early February. Since crossing the 50-day moving average in March last year the current price has been steadily increasing, despite the odd dip below the 50-day moving average. On February 8, 2010 the current price broke below the 50-day moving average and then broke below the 100-day moving average on March 5, 2010. Not only is this a technically bearish signal but also relative strength and MACD are also bearish from a technical perspective.

In the past year, XRB appears to be positively correlated to the S&P/TSX. Not the case in the past month. So what has happened? Scotia Capital reported that the bond market sold off as investors had a renewed appetite for risk and equities rallied. Government of Canada bonds weakened on the back of strong corporate earnings and a much better than expected Q4 GDP. XRB may have also been affected by the view that interest rates could rise in Canada in the 2nd half of 2010. It is worth noting that XRB holds mostly government bonds and 98.40% of its holdings mature in greater than 10 years. As mentioned above the duration on XRB is 15.77 years so any news of rising rates would scare off investors. The other variable that will affect this fund is inflation. Real Return bonds have a portion of their value pegged to the inflation rate. This should work in a positive way if we expect inflation to rise. The most recent debate has been whether inflation or deflation will be a problem and I think the jury is still out, however neither seems to be taking the lead. Mixed data has given the governments the ability to message inflation is not a risk at the moment so rates don’t need to rise until later. It is rare that interest rates move higher unless they are accompanied by inflation but it is also possible that rates could rise even without inflation. After assessing this fund, it appears that like the markets there are a number of factors beyond inflation influencing where this fund will go. In a rising interest rate environment it is a legitimate choice for fixed income as long as you are active with it and you understand all of the variables that influence it’s price changes.