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Understanding Real Return Bonds (RRBs) In Canada 

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It is a fact that inflation affects your fixed-income portfolio and erodes your wealth. Why so? The reason is simple; rising inflation reduces the purchasing power of the money you will earn in the future. Thus, to counter the effect, we see an emergence of several inflation-linked investment products in which your return adjusted as per the inflation prevailing in the economy.  

Real return bonds are one such investment products that can help you beat inflation. Let us gain a comprehensive understanding of them through this article.  

RRB

Source: Freepik

What Do You Mean by Real Return Bonds? – Explanation in Simple Points  

  • The Government of Canada issues the real return bonds or RRBs.  
  • Like every other debt instrument, these also carry a pre-determined coupon rate to calculate the interest payments.  
  • The interest paid half-yearly or semi-annually to the investors of RRBs.  
  • These are certain bonds countering the effect of inflation by increasing both the principal amount and interest payments.  
  • The RRBs consider the inflation as calculated by the Consumer Price Index (CPI)   
  • If you have an active RRSP (Registered Retirement Savings Plan), RRIF (Registered Retirement Income Fund), Registered Education Savings Plan (RESP), Or Tax-Free Savings Account (TFSA), and planning your retirement, invest your contributions in the RRBs.  

 How Does a Real Return Bond Work and Protect Investors from Inflation?  

Apart from minimal default risk (since these are government bonds issued by the Government of Canada), the advantage of real return bonds is protecting their investors from the effects of inflation. 

An RRB does so by effecting two different adjustments: 

S. No.  Adjustment of: Description 
I. Principal Amount • When you buy an RRB, your principal amount is adjusted semi-annually following the inflation rate.
• In case there is an increase in the inflation rate, your principal amount will also be increased.
• On the flip side, your principal amount will decrease in case there is a fall in the interest rate.
II. Interest Income • The cash flows from the RRB or the interest will also increase or decrease by the inflation rate.
• Your coupon rate will remain the same, but there will be a change in the interest income when it is applied to the inflation-adjusted principal amount.

Let us understand the practical working of an RRB through the example below:  

  • Michael Williams is a conservative investor and aspires to invest $500,000 into Real Return Bonds Issued by the Government of Canada.  
  • He approached his financial advisor, who recommended to him the latest series of RRB, having:  
    • A Face Value of $1,000  
    • A Coupon Rate of 3.50% per annum  
  • Michael purchased 500 real return bonds and invested his entire savings of $500,000 

Let us now divide the working of an RRB into three distinct phases: 

Phase I: The First Rise in Inflation Rate 

  • In the first 6-months of purchase, the inflation rose by 1.25%.  
  • The real return bonds protected Michael from capital erosion by enhancing:  
    • The value of his investment is from $500,000 to $506,250 ($500,000 x 101.25%) ($𝟓𝟎𝟎,𝟎𝟎𝟎 * 𝟏𝟎𝟏.𝟐𝟓%) 
    • The interest income from $8,750 [($500,000 * 3.50%) * 6/12] to $8,859 [($506,250 * 3.50%) * 6/12]

Phase II: The Second Rise in Inflation Rate 

  • In the next 6-months, the inflationary situation persisted, and the inflation rate again increased by 1%.  
  • The inflation-adjusted principal amount of Michael increased by 101% and amounted to: 

New Principal Amount: $506,250 x 101%=$511,312.5

  • The interest income also increased and amounted to $8,948 ($511,312.5 x 3.50% x612)$511,312.5 x 3.50% x612) 

Phase III: The Fall in Inflation Rate

  • Because of active interventions and significant monetary policy changes, the Bank of Canada could tame inflation and reduce it by 1.50%. 
  • Because of a fall in the inflation rate, Michael’s principal amount and interest income also reduced in the following manner: 
    • Principal Amount = $511,312 * (100−1.50)% = $511,312 * 98.50% = $503,642
    • Interest Income = $503,642 * 3.50% * 6/12 = $8,814
RRB in Canada
Source: Freepik

What Are the Pros Of A Real Return Bond? 

RRB is a preferred investment option and gains support from several investors due to the following pros: 

Pros Explanation 
Protection from Inflation • One of the biggest benefits of holding an RRB is that it protects you from inflation prevailing in the economy
• By adjusting your principal amount and your interest income, you never tend to lose your purchasing power.
Zero Default Risk  • The RRBs are issued by the Government of Canada as sovereign bonds.
• The principal amount and interest are fully backed by the government and do not carry any default risk
• After buying RRBs, you can be assured that you will always get a semi-annual return from your investment
Balances Your Portfolio Risk  • Since RRBs are backed by the Government of Canada, you can add them to your portfolio to balance the overall portfolio risk.
• They have zero chances of default and can reduce the overall risk of your otherwise risky portfolio comprising equity, derivatives, foreign currencies, etc.

What Are the Cons Of A Real Return Bond? 

Of course, an RRB is marred by several cons as well. These are: 

Cons Explanation 
Unstable Cash Flow/ Interest Income  • If you are a fan of stability, then an RRB will certainly upset you.
• Your semi-annual cash flows or interest income will always be adjusted following the inflation rate prevailing in the economy.
Considers only CPI  • A RRB considers only the inflation rate as measured by the Consumer Price Index
• Several other indexes broadly measure inflation prevailing in the economy
• As per critics, an inflation rate measured by CPI is narrower and might not be able to hedge you completely against the price rise. 
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