What Are Real Return Bonds?

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.


3 Responses to What Are Real Return Bonds?

  1. Karan Batra says:

    Real Return bonds are better as compared to normal bonds as they offer returns over and above the Inflation Rate and therefore the real value of money never gets depreciated whereas in non-real return bonds the value of money may get depreciated in extreme cases wherein the Inflation Rate is more than the Interest Rate offered

  2. Ed Arakelian says:

    I own some TD Real Return Bond funds which in the last 3 months have been battered. What is the reason for this? Should I stay the course and hold on to them?

    Tks.

    • Boomer says:

      @Ed Arakelian: RRBs focus on protecting you from inflation which has remained low of late.

      Usually you would expect interest rates and inflation to correlate but in the past few months that wasn’t the case.

      RRBs will perform poorly if inflation turns out to be lower than expected.
      Inflation actually decreased a bit – 0.2%
      They are also vulnerable to rising interest rates. GofC long term bonds yields rose from 2.37% on April 30 to 2.63% on May 31.

      If you sell now you may possibly realize a capital loss. Also, you would need an alternate investment for your money.

      The portfolio advisor of TD Real Return Bond fund believes yields will rise in the future. Do you expect interest rates to rise? Then hold on.

      RRB’s make a good addition to a diversified fixed income portfolio.

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