Real Return Bonds

Bonds have two main distinguishing characteristics. First, unlike common stocks, they usually only exist for a finite period of time (e.g., for thirty years), at the end of which you are repaid your capital. The exception to this is a type of rarely issued bond called a perpetuity, which never repays your capital. Perhaps the most famous of this type of bond is known as the Consol, and was issued in the past by the government of the United Kingdom.

The other distinguishing feature of a bond is that the company that issues it is contractually obligated to compensate you for the use of the capital you provide. In contrast, a company issuing common stock has no legal obligation to pay any dividends on it. A bond's contractual compensation is known as its rate of interest. If you purchase the bond for 100% of its face value, the rate of interest you receive on the bond will be equal to its "coupon rate" or the rate the issuing company has contractually agreed to pay. However, if you purchased the bond for less than its face value (that is, "at a discount"), then the actual rate of interest you receive (also known as the bond's "yield") will be greater than the coupon rate. In contrast, if you pay more than face value for the bond (that is, you purchase it "at a premium"), your yield will be less than the coupon rate.

Finally, the total annual return on your bond is a function not only of its yield, but also of any changes in its market value. For example, if, in a given year, you received a yield of five percent, but the market value of the bond declined by four percent, your total rate of return would be only one percent.

This simple example makes an important point: Fixed income investments expose you to different types of risk. The first type is usually called market risk. Because the future stream of cash flows you receive when you buy a nominal return bond is fixed (i.e., the coupon payment on most bonds doesn’t change over time), an increase in interest rates will cause the present value of the bond to decline (that is, the amount for which you could sell the bond today will decline in value when interest rates rise). This decline in the value of your capital also reduces the total rate of return you receive on your investment. For example, if a bond with an annual coupon of five percent experiences an eight percent loss in market value due to a rise in interest rates, your total return on it for the year would be negative three percent (assuming you bought it for 100 percent of face value). Two underlying factors can cause market interest rates to increase: a rise in inflation, or a rise in real interest rates. Inflation is the year to year change in the average price level in a country. The real rate of interest is the annual rate of return that would be required by investors to induce them to loan money in a world with no inflation. The market or nominal rate of interest is composed of the real rate plus inflation.

There are a number of ways you can limit your exposure to increases in market interest rates. First, you can invest in bonds with shorter rather than longer maturities. All else being equal, the longer the maturity of a bond, the bigger the reduction in its present value that will result from a rise in interest rates. Of course, the flip side of this statement is also true: if interest rates decline, bonds with longer maturities will experience a larger increase in value than bonds with shorter maturities.

The other way you can protect yourself from market risk is to find a way to eliminate your exposure to changes in the rate of inflation. Until recently, this was very difficult to do. However, in the past decade, more and more governments have begun to issue what are known generically as "real return bonds" (e.g., TIPS or Series I Savings Bonds in the U.S.). In the UK, these are known as "index-linked bonds." The unique feature of these instruments is that investors are guaranteed to receive a constant real rate of return if inflation increases. Depending on the way the bond is structured, they may even provide some protection against deflation. For example, in the United States, Treasury Inflation Protected Securities (TIPS) guarantee that the principal value of the bond (which is adjusted with inflation) will not fall below its face value, even if a prolonged period of deflation suggests that this is what should be done to maintain its real return. As a result, the real return on these government bonds would actually rise during a prolonged deflation, though by less than the rise in the real return on nominal government bonds. To put it slightly differently, real return bonds protect both principal and interest against inflation, and (depending on their structure) sometimes principal against deflation. By comparison, nominal return bonds (that is, any bond that isn’t a real return bond) protect neither principal nor interest payments against inflation, but protect both of them against deflation.

On the other hand, real return bonds still leave an investor exposed to changes in the real rate of interest. For example, during periods when the economy is growing quickly, demand for capital and real rates of interest can rise, causing the capital value of real return bonds to fall. The opposite can happen during recessions. Still, because they eliminate some, but not all of the risk associated with a change in nominal interest rates (which can be caused by changes in expected inflation and/or real rates), real return bonds should be less volatile (that is, have lower standard deviations) than nominal bonds of comparable maturity.

Real Return Bonds are currently available in five of the six functional currencies covered by The Retired Investor. They were first issued by the government of the UK in 1981, Australia in 1985, Canada in 1991, Sweden in 1994, the US in 1997 and France in 1998. So far, Japan has not issued any (which is logical, as they are in a prolonged period of deflation). Current real yields on these instruments are quite closely grouped (reflecting a highly efficient global fixed income market), and range from 2.92% in Canada to 1.79% in the Eurozone. The average yield for all five regions is 2.33%.

Looking more closely at TIPS in the United States, their arithmetic average annual real return since they were first issued in 1997 has been 3.89% (through the end of 2002). The standard deviation of these returns is 4.27%. This is lower than the standard deviation on the different types of nominal bonds we will look at, but it is not zero; there is still some risk in holding real return bonds. Since they have been issued, returns on TIPS have had a low correlation with the returns on other asset classes; in other words, they provide substantial diversification benefits to a portfolio. However, the skewness and kurtosis of the return distribution for TIPS are not pretty. The former is (.52), while the latter is high at 3.11. In other words, since they were first issued six years ago, there have been more and bigger negative real return surprises than positive ones for holders of TIPS. Frankly, we think these data vastly overstate the risk of holding TIPS. They seem to reflect two factors, only one of which will persist in the future.

As we have mentioned, the factor that will persist is changes in the real rate of interest over the business cycle. In this regard, a point to keep in mind is that since real return bonds first introduced in the United States in 1997, the economy has generally been growing, and most of the surprises have therefore been on the downside (that is, increases in the real rate of interest). This may have exaggerated the statistical riskiness of this asset class. The factor that will change is the excess volatility associated with the introduction of this asset class, and investors’ initial learning process. For example, real return bonds have been since 1981 in the United Kingdom, and the skewness and kurtosis of their returns are more in line with other government bonds (that is, positively skewed, with low kurtosis).

In light of all these considerations, the estimate of future risk and returns that we will use in our asset allocation models for real return bonds is an annual real arithmetic return of 2.50%, and a standard deviation of 2.50%. So, to summarize the pros and cons of investing in this asset class: