Canada’s year-over-year inflation rate stood at 7.6 per cent in June 2022, just shy of the 39-year high rate of 8.1 per cent recorded in July 2022. Wary investors looking for inflation protection may turn to products that offer a hedge against inflation — but it’s important to look at exactly what these products promise before committing.
“Investment products that promise to provide protection from inflation may actually do just that,” says Timothy Hicks, chief investment officer at Lysander Funds Limited, an experienced, Canadian, independently-owned investment fund manager. “But they may not provide you with the return on investment you’re hoping for.”
For example, Government of Canada Real Return Bonds (RRBs) or U.S. Treasury Inflation-Protected Securities (TIPS) both offer inflation protection indexed to the Canadian and U.S. consumer price index respectively. Essentially, the coupon rate remains fixed while extra payments are periodically added to the investment to compensate for inflation.
These bonds appear to be exactly what investors who are frightened about the effects of future inflation would want. However, real return bonds contain subtle, but important, differences from regular or “nominal” bonds. With most bonds, the yield-to-maturity is the interest rate that links the future payments with the current price of the bond. The lower the price, the higher the yield. If yield rises, the price falls.
With real return bonds the concept is the same, except that the effective price comes from the bond’s real yield (i.e., the yield after inflation). When RRBs were first issued in Canada their real yields were over 4 per cent. Their real yields now are a bit over 1 per cent. There is nothing stopping these real yields from rising to more reasonable levels and that would be negative for their prices. In fact, the RRB issued in June 2021 at roughly $100 that has a 0.25 per cent real coupon maturing in December 2054 has a price of roughly $76 at time of writing. That is a significant price decline that could get worse if real yields rise further.
“You have to look at inflation-linked bonds over the long term and consider the effect of duration risk on the inflation protection you’re receiving,” Hicks says. “You have to know what those bonds are worth today at the same time as you’re contemplating the value of payments far into the future. Even if those future payments are increased by the actual rate of inflation, you have to decide whether that will provide an adequate return.”
Other investment products offer some protection from rising interest rates and in turn provide some protection from inflation because it’s likely that central banks will continue to raise interest rates to combat inflation.
Floating rate notes (FRNs or “floaters”), for example, are bonds that pay a variable coupon tied to a benchmark floating interest rate. If issued by a corporation, they may include an additional risk premium. These products are in highest demand when investors expect interest rates will rise. If rates fall, the investor receives a reduced coupon payment.
“While some FRNs have a 100-year original term, they’re typically of shorter term and not designed specifically as a hedge against inflation,” Hicks say. “However, with inflation hovering around 8 per cent, you wouldn’t currently receive enough of a return to compensate you on a real basis for investing in many FRNs, however at least the coupon payments rise if the benchmark interest rate rises.”
Canso Investment Counsel, the portfolio manager for certain Lysander Funds, currently holds select FRNs in some of the funds. And while it isn’t philosophically opposed to investing in inflation-linked bonds, Hicks notes that they don’t form part of its current investment portfolio simply because there isn’t a strong enough investment case for owning them in today’s market.
Bank loans can also be repackaged as securities with an inflation hedge — for example, a floating rate tied to a short-term interest rate. But Hicks notes that these loans often introduce credit risk when they’re issued on behalf of lower-quality borrowers.
Exposure to inflation-linked bonds and FRNs is typically achieved through the investment funds that hold them and the level of liquidity can vary for each. Loans settle in seven days or longer, mutual funds and ETFs usually in two days.
“However, if there’s a run by investors looking to cash out, funds comprised of loans may take longer to settle,” says Hicks. “That’s because some underlying bank loans that make up a fund will have to be sold in order to satisfy the demand to redeem the units. Necessary paperwork takes time to file and that can add to the delay.”
Hicks notes that no single investment product provides a guaranteed hedge against inflation while guaranteeing adequate returns — including gold and real estate.
“Canso believes that an actively-managed, diversified portfolio of short and long-term investments offers the greatest potential for returns against an inflationary landscape,” Hicks says. “That can include equities and bonds offering both fixed and floating rates that compensate investors adequately for the various risks they’re taking.”
For a more in depth examination by Lysander Funds of the potential risks and rewards of exposure to inflation-linked bonds through TIPS, see: “Interest Rates Are Rising – Is Now the Right Time for TIPS?”
For more information on Lysander Funds, visit: www.lysanderfunds.com
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This story was created by Canadian Family Offices’ commercial content division, on behalf of Lysander Funds Limited, which is a member and content provider of this publication.