Understanding Real Return Bonds

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1 Monthly Market Snapshot AUGUST 2016 Fund Research Global Portfolio Advisory Group Understanding Real Return Bonds February 2, 2017 Joel Beriault / (416) joel.beriault@scotiawealth.com After years of muted price expansion investors are now looking for an escalation in inflation as a result of the progrowth policies laid out by President-elect Donald Trump. In Canada, the federal Liberal government announced in its most recent budget that infrastructure spending would be ramped up by $11.9 billion over two years. An era of expanded economic growth in the U.S. and Canada could potentially drive wages and the price of goods and services higher. The Consumer Price Index (CPI) in the two countries is expected to increase from the current 1.3% rate in the U.S. (1.4% in Canada) to 2.5% in the U.S. (2.1% in Canada) in 2017 (Scotiabank. Forecast Tables, January 17, 2017). And bond yields have ramped up higher since early fall, a clear indication that market participants are on the lookout for inflation. Inflation erodes purchasing power and we ve been fielding inquiries from advisors regarding ideas on investment options that can help combat inflation. Real return bonds are a possible solution here. But what exactly are these instruments, how do they work, can they adequately defend against inflation, what product options exist for retail investors and how are these products best used in a portfolio? What Are Real Return Bonds? Real return bonds (RRBs) are debt obligations that offer protection against inflation. They are similar to conventional bonds in that they are issued with a fixed coupon rate, interest is paid twice a year and they have a specific maturity date. That is where the similarities end. Unlike a conventional bonds, the principal and interest payments of RRBs rise with inflation (more on this below How Real Return Bonds Work? ). The government of Canada is the most prolific issuer of these instruments in this country and some provinces issue RRBs as well. The Federal Government has been issuing RRBs since 1991, but in fairly limited amounts (about $2 billion a year). The outstanding value of all Government of Canada-issued RRBs is currently $74 billion (based on data from TD Asset Management). These bonds are issued based on the government s issuance/auction calendar. The calendar is updated throughout the year, typically quarterly to give the market clear and predictable information with respect to government bond supply. How Real Return Bonds Work? The biggest difference between a conventional bond and a real return bond is that the principal and coupon payment of the RRB is adjusted to reflect the changes of inflation (as measured by the total Consumer Price Index (CPI)). For example, assuming no inflation, a RRB with a par value of $1,000 and a fixed semi-annual coupon of 2% would pay interest of $20 every six months. If CPI were to rise 1% in the six months after the bond is issued, par value would be adjusted to $1,010 ($1,000 x 1.01) and the semi-annual interest payment would increase to $20.20 (2% x $1,010). Please be advised that this material is not to be distributed to residents of the European Union Registered trademark of The Bank of Nova Scotia, used under licence. Trademark of The Bank of Nova Scotia, used under licence. Scotia Wealth Management consists of a range of financial services provided by The Bank of Nova Scotia (Scotiabank ); The Bank of Nova Scotia Trust Company (Scotiatrust ); Private Investment Counsel, a service of 1832 Asset Management L.P.; 1832 Asset Management U.S. Inc.; Scotia Wealth Insurance Services Inc.; and ScotiaMcLeod, a division of Scotia Capital Inc. Wealth advisory and brokerage services are provided by ScotiaMcLeod, a division of Scotia Capital Inc. Scotia Capital Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.

2 Global Portfolio Advisory Group Real Return Bonds // 2 The coupons offered by RRBs bonds today range from 1.25% to 4.50% and these are available with maturities as early as 2018 and as late as It is important to understand that RRBs have lower coupons than traditional bonds because their principal and interest payments are adjusted up (or down) with inflation. For example, if an investor buys a 30 year RRB with a quoted yield of 0.43% and holds it until maturity, he/she will earn a return of 0.43% plus the inflation rate as measured by CPI over that period. If we assume an inflation rate of 1.8% during the lifespan of the RRB, the investor will then earn a return of 2.23% (0.43% + 1.8%). On the other hand, and everything else equal, a nominal bond with a maturity of 30 years that yields 2.23% implies in theory that investors should be indifferent between holding a 30 year RRB or a 30 year nominal bond. However, inflation expectations can be adjusted upwards and downwards over time. Put differently, the difference between the yield of an RRB and a conventional bond represents the market s expectation for inflation and this difference is also known as the break-even inflation rate. In our example above, the break-even inflation rate is 1.8%. If the break-even inflation rate moves higher, the implication is that the market is expecting rising inflation. From Chart 1 below we can see that break-even inflation rate (light blue line) was fairly stable in the 2% range for most of 2012, 2013 and 2014 before dropping below the 2% level in You can see that there was a clear move upward in the summer, suggesting that the market is expecting an increase in inflation. Chart 1: Break-Even Inflation Rate. November 2011 to December 2016 (%) Source: Bloomberg, Odlum Brown Factors Impacting Real Return Bonds Returns If held until maturity RRBs will repay the principal and the coupons along the way in inflation-adjusted dollars. In this sense they are a perfect hedge against inflation. However, the price volatility of these instruments can be quite high. RRB pricing depends on the interaction of two factors: the movement of real interest rates and inflation expectations. There are essentially four different possible environments that can be examined for RRBs: 1. Real interest rates are falling and the inflation increases faster than expected. This is the best environment for RRBs when real interest rates fall but there s a rise in unexpected inflation. This type of environment which is also known as stagflation was present in Canada during the 1970s. 2. Real interest rates are rising and the unexpected inflation is low. This is the worst environment for RRBs. When interest rates are increasing, consumers will tend to save more to benefit from the higher yields but with less disposable income they spend less thereby reducing inflation.

3 Global Portfolio Advisory Group Real Return Bonds // 3 3. Real interest rates are falling but the unexpected inflation is low. This is the opposite of the previous scenario. Again, the outcome is uncertain in this environment because it depends on the relative impact of each factor. While a decrease in real interest rates are positive for RRBs, low expected inflation can offset that potential gain. 4. Real interest rates are rising but the unexpected inflation is high. The outcome is uncertain in this environment because it depends on the relative impact of each factor. For example, high expected inflation is generally positive for RRBs but not if it s accompanied by rising rates. This is because rising rates have a negative impact on the price of RRBs and therefore the two factors (high expected inflation and rising interest rates) would offset each other. What Are the Shortcomings of Real Return Bonds? RRBs have long maturities and are long duration instruments, meaning they are highly sensitive to changes in interest rates. One particular volatile period for bonds was during the Taper Tantrum in 2013 where the FTSE TMX Canada Real Return Bond index was down by a whopping 11.6% compared to the FTSE TMX Canada Universe Bond index which shed 3.9%. Other shortcomings of RRBs: They do not provide consistent income to investors as the principal and interest payments are adjusted with inflation. The interest payments can also be adjusted downwards in the event that inflation (CPI) decreases. RRBs are not widely available and therefore investors must be aware of is the lack of liquidity of RRBs versus conventional bonds. As mentioned earlier, the Federal Government issues a limited quantity of RRBs and therefore it is not recommended investors purchase RRBs directly on the market. We recommend investors purchase RRBs via an ETF or mutual fund (refer to the What are the Options? for more information). Table I: Rate of Returns and Standard Deviation Market Indices, to 12/31/16 (%) Index 3 Yr RoR 3 Yr Std Dev 5 Yr RoR 5 Yr Std Dev Taper Tantrum RoR (May 21 - Sep. 18, 2013) FTSE TMX Canada Real Return Bond FTSE TMX Canada LT All Governments FTSE TMX Canada LT Bond S&P/TSX Capped Real Estate TR FTSE TMX Canada MT Bond FTSE TMX Canada All Government Bond FTSE TMX Canada Universe Bond FTSE TMX Canada All Corp Bond FTSE TMX Canada ST Bond S&P/TSX Composite TR S&P 500 TR CAD Source: Morningstar What are the options? In Canada there are two ETFs and six mutual funds that are focused on RRBs. XRB was launched over 10 years ago and is by far the larger of the two ETFs (both are passive strategies). On the mutual fund side, the TD Real Return Bond fund is by far the oldest and biggest within the RRB category. It was launched in 2001 and holds $618 million in assets. Out of the six mutual fund options, all are actively managed with the exception of the PowerShares Real Return Bond fund. In the U.S. investors can choose from 12 different RRB ETFs. The most popular ETF within that category is the ishares TIPS Bond ETF (TIP) with over $21 billion in assets.

4 Global Portfolio Advisory Group Real Return Bonds // 4 Table II: Mutual Fund and Exchange Traded Funds, to 12/31/16 (%) Ticker 1 Yr 1 Yr Std 3 Yr 3 Yr Std 5 Yr 5 Yr Std AUM ETFs/Mutual Funds(CAD) MER /Code RoR Dev RoR Dev RoR Dev $Mil ZRR BMO Real Return Bond ETF XRB ishares Cdn Real Return Bond CCM1203 IA Clarington RRB Sr F RBF5650 PH&N Inflation-Linked Bond F AIM54207 PowerShares Real Return Bond F ATL010 Renaissance Real Return Bond F PCA315 SEI Real Return Bond Class F TDB855 TD Real Return Bond - F Source: Morningstar The Bottom Line There is very little risk of default for real return bonds as they are backed by the Federal, or in some cases, a Provincial Government of Canada. As far as the inflation question is concerned, RRBs can indeed defend against inflation if they are held until maturity. However, as demonstrated earlier, RRBs can exhibit extreme bouts of volatility as experienced in 2013 and therefore they are not recommended for investors that have a low risk tolerance or a short term investment horizon. It is important to keep in mind that the performance of RRBs depends primarily on the interaction of two factors: inflation and interest rates. RRBs thrive in an environment of declining interest rates and rising inflation rates. When inflation and interest rates are both expected to increase, the outcome is uncertain because it depends on the relative impact of each factor. In this sense, RRBs would be suitable for investors who expect inflation to rise higher than what the market is expecting. RRBs are more appropriate investments for investors with very long investment time horizons who can tolerate potential wild swings in performance in the short to medium term. Because of their long duration characteristics, RRBs should not be held by investors who would like to maintain or to reduce the duration of their fixed income portfolios.

5 Global Portfolio Advisory Group Real Return Bonds // 5 Important Disclosures This material does not include or constitute an investment recommendation, and is not intended to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and talk to your investment advisor. The author(s) of the report own(s) securities of the following companies. None. The supervisors of the Portfolio Advisory Group own securities of the following companies. None. Scotia Capital Inc. is what is referred to as an integrated investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. As a result we recognize that we there are inherent conflicts of interest in our business since we often represent both sides to a transaction, namely the buyer and the seller. While we have policies and procedures in place to manage these conflicts, we also disclose certain conflicts to you so that you are aware of them. The following list provides conflict disclosure of certain relationships that we have, or have had within a specified period of time, with the companies that are discussed in this report. General Disclosures The ScotiaMcLeod Portfolio Advisory Group prepares this report by aggregating information obtained from various sources as a resource for ScotiaMcLeod Wealth Advisors and their clients. Information may be obtained from the Equity Research and Fixed Income Research departments of the Global Banking and Markets division of Scotiabank. Information may be also obtained from the Foreign Exchange Research and Scotia Economics departments within Scotiabank. In addition to information obtained from members of the Scotiabank group, information may be obtained from the following third party sources: Standard & Poor s, Valueline, Morningstar CPMS and Bloomberg. The information and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. While the information provided is believed to be accurate and reliable, neither Scotia Capital Inc., which includes the ScotiaMcLeod Portfolio Advisory Group, nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report is provided to you for informational purposes only. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Nothing contained in this report is or should be relied upon as a promise or representation as to the future. The pro forma and estimated financial information contained in this report, if any, is based on certain assumptions and management s analysis of information available at the time that this information was prepared, which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will be realized Opinions, estimates and projections contained in this report are our own as of the date hereof and are subject to change without notice. Copyright 2012 Scotia GBM Inc. All rights reserved Registered trademark of The Bank of Nova Scotia, used by ScotiaMcLeod under license. ScotiaMcLeod is a division of Scotia Capital Inc. Scotia Capital Inc. is a member of Canadian Investor Protection Fund.