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Analysis: One of the biggest threats to the fixed income component of one’s portfolio is the impact inflation can have on its value. One product type which can help to address this erosion of value is a real return bond fund. Real return bond funds invest in real return bonds, which are bonds that adjust both the coupon payment and the principal value based on the level of inflation in the economy.
The TD Real Return Bond Fund is the largest and oldest real return bond fund in the country. Launched in November 1994, the fund today has $1.7 billion in assets. The fund holds real return bonds that are issued by the Government of Canada, the provinces and some corporations. The managers have the ability to hold U.S. TIPS, but rarely do.
The fund is essentially a buy and hold fund where the managers will buy and hold the real return bonds. This is done for 2 main reasons – the size of the fund and the general illiquidity of the market. The portfolio is very concentrated holding only 13 bonds, with the top 10 names making up 95% of the portfolio. Normally, this level of concentration would be a concern, but given that all of the top 10 names are either Government of Canada or provincial issues, concentration is not really an issue.
Performance has been decent, with real return bonds outpacing traditional bonds of late. The Fund itself has been posting performance that is middle of the pack recently, with lower cost alternatives outperforming. This fund has an MER of 1.50%, slightly above the category median.
Volatility within the real return bond sector is generally expected to be higher than the volatility of traditional bonds. In fact, the TD Real Return Bond Fund has shown a level of volatility that is two and a half times more volatile than the broader DEX Bond Universe Index. The main reason for this is that most real return bonds tend be very long term bonds with maturities like 2021, 2036 and 2041. Traditional long term bonds tend to be much more volatile than shorter term bonds and the real return bonds are no different.
While the longer term outlook for real return bonds appears to be favourable, the short to medium term is less favourable. The level of economic activity remains well below full capacity and the threat of inflation remains muted. Given that these bonds trade off of inflation expectations, the near term outlook is muted. Therefore, we would be reluctant to have much real return bond exposure in our portfolios and would likely lean towards a fund where the manager has the ability to add some real return bond exposure to the fund when they feel the opportunities exist.