Another RRSP season has come and gone. Hopefully, you had a chance to invest wisely. You should take the opportunity to review your investments and make sure they are appropriate for the current financial climate.

I had a number of questions about bullet-proofing one's portfolio for the volatile market. As a firm believer in market indexes, I advised my clients who are growing their portfolio's to avoid fixed income instruments if they want to grow the monies for retirement purposes. You just have to look at an Andex report that compares the growth of Equities versus Bonds over a 30 year investment horizon and you will see the argument is for buy and hold.

That being said, there is an argument for the short term for Real Return Bonds. Bonds, you say? Why bonds are priced inversely to interest rates. And interest rates are at all time lows? What are you talking about?

To answer this question, let's take a look at Real Return Bonds (RRB's) and how they work. As you know, the price of nominal bonds will move inversely with nominal interst rates. RRB's , however, are a little different. Their price will move inversely with REAL interest rates. Real interest rates are defined as nominal rates minus inflation. So, the two factors that will impact the price of RRB's are interest rates on similar term bonds and inflation. However nominal rates and higher inflation is good for the pricing of real return bonds while rising interest rates and declining inflation are bad in the short term as they will lead to higher real rates and therefore a decline in the price.

Last year (2001) was a challenging year for real return bonds because inflation expectations fell dramatically with lower energy prices, while long term interest rates stayed relatively flat to lower during the year. Currently, RRBs look attractive as nominal rates have come down already, and we are beginning to see inflationary pressures.

So...Why hold Real Return bonds?

1) Inflation Protection: Inflation is the biggest enemy of fixed income investments and real return bonds are the ONLY true hedge against this risk. Other investments such as gold or real estate have traditionally acted as an inflation hedge, but none are directly tied to the inflation rate as RRBs are. RRSP investors in particular should be very keen on protecting the purchasing power of their retirement money from the ravages of inflation.

2) Expected Decline in Real Rates: Real rates should trend lower over the next few years helping the performance of RRBs. Real rates are a function of the risk premium that the government faces when issuing bonds. If their fiscal situation improves, this premium should decline and as mentioned, falling real rates are good for RRB's. Adding RRB's allows investors to get better returns for the amount of risk they are willing to take.

3) Inflation Expectations: The threat of inflation has been very subdued over 2001. We have seen recently, however, the bondmarket pricing in inflation and discounting a further rate cut. If indeed the agressive rate cuts and tax cuts in both Canada and the US have a stimulating affect on the economy, inflation could become a greater concern playing into the hands of RRBs.

4) Supply and Demand: On the supply side of the equation, after eliminating any new 30 year government bond issues in the US, there is a good chance that Canada could follow suit with a similar move, while also getting rid of the RRB issuances which have comparable terms to maturity. The demand side also looks to be improving as more and more pension plan investmetns are taking a serious look at this asset calss for inflation protection.

5) Correlation: Real Return bonds should be considered a separate asset class and as such allow for enhanced diversification and portfolio optimization.

The bottom line is, you may see equity type returns on RRB's with some degree of safety of capital.

If you would like to find out more about this financial product, please feel free to email me at johnk@lms.ca or phone (416)-595-7484 ext. 305