Real-return bonds pay a return adjusted for inflation. But when you buy a real-return bond, you are only protecting yourself against unanticipated rises in inflation. For investors looking for diversification, a real-return bond ETF might be an option to consider.

Real-return bonds pay you a rate of return that’s adjusted for inflation, but that’s not always as promising as it seems.

When a real-return bond is issued, the level of the consumer price index (CPI) on that date is applied to the bond. After that, both the principal and interest payments are typically adjusted every six months, upwards or downwards from that base level, to compensate for a rise or fall in the CPI.

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In general, Government of Canada real-return bonds pay interest semi-annually, on June 1 and December 1. Some investors may prefer a real-return bond ETF for easier access to these securities.

Look at this theoretical example to understand how a real-return bond works

The Bank of Canada issues $400 million of 30-year bonds maturing on December 1, 2049. The bonds have a coupon, or interest rate, of 2%.

If after six months from the date of issue, the new CPI level is, say, 1% above the level of the CPI on the issue date, then each $1,000 of bond principal is adjusted to $1,010 of bond principal ($1,000 x 1.01). The semi-annual interest payment is then $10.10 ($1,010 x 2% / 2).

If after 12 months, the level is 2% higher, then the bond principal is adjusted to $1,020 ($1,000 x 1.02), and the interest payment rises to $10.20 ($1,020 x 2% / 2).

Consider these three important factors to realize benefits with real-return bonds

1. The price you pay for real-return bonds reflects the anticipated rate of inflation. In other words, if investors feel that inflation will rise 2% over the long term, the price of the bond will reflect that future inflation increase and its effect on the bond’s principal and interest payments. So, when you buy a real-return bond, you are only protecting yourself against unanticipated rises in inflation.
2. When the inflation rate falls over a six-month period, the principal and interest payments of a real-return bond fall. In times of deflation, the inflation rate turns negative. In a prolonged period of deflation, the principal of a real-return bond could fall below the purchase price. Interest payments would fall, as well.
3. As with regular bonds, holders of real-return bonds must pay tax on interest payments at the same rate as ordinary income. That income gets taxed at the investor’s marginal rate. In addition, holders of real-return bonds must also report the amount by which the inflation-adjusted principal rises each year, as interest income, even though you won’t receive that amount until the bond matures. That amount is added to the bond’s adjusted cost base.

If the CPI level falls, that reduces the inflation-adjusted principal. You deduct the amount of that reduction from your taxable interest income that year, and also subtract it from the adjusted cost base.

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Find out how real-return bonds compare to regular bonds and if they make better additions to your portfolio

In simple terms, a bond is a form of lending whereby you lend money to a corporation or government. In return, a bond pays a fixed rate of interest during its life. Eventually, a bond matures, and holders get the bond’s face value—but nothing more. Receiving the fixed interest and face value at maturity is the best that can happen. Note, though, that in some cases, corporate bonds can go into default. As well, inflation can devastate the purchasing power of bonds and other fixed-return investments.

Furthermore, bonds also generate more commission fees and income for your broker, compared to stocks, especially if you buy them via bond funds and other investment products.

Overall, it’s true that bonds may reduce the volatility of your portfolio. That’s because bonds and stocks do tend to move in opposite directions, up to a point. However, when interest rates on long-term bonds are so low, then it generally makes little sense to hold them.

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Is it worth holding a real-return bond?

Even though inflation is still elevated–after running at 40-year highs in 2022–inflation-protected bonds are still less appealing than they were in the 1970s, when inflation and interest rates had the potential to unexpectedly move higher.

Note that if you do hold real-return bonds, they are best held in an RRSP or RRIF. You’ll still be taxed at the same rate as ordinary income, but you’ll postpone those income-tax payments until you withdraw the funds from your RRSP or RRIF.

Are bonds good investments for a diversified portfolio?

We feel that real-return bonds, like regular bonds, mainly ensure that you’ll earn a low return on your investment. We continue to recommend that you invest only a small part of your portfolio, if any, in bonds and fixed-income investments.

Instead, focus your investing on building a diversified portfolio of well-established companies with a long history of paying dividends. We recommend a number of these types of stocks in our newsletters. While a real-return bond ETF can provide some inflation protection, it may not offer the growth potential of dividend-paying stocks.

We also recommend our three-part Successful Investor approach to investing because equities are bound to be more profitable than fixed-return investments over long periods:

1. Invest mainly in well-established, mostly dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

For those still interested in fixed-income options, a real-return bond ETF could be worth researching further.

In summary, real-return bonds are fixed-income securities that offer returns adjusted for inflation. These bonds are designed to protect investors from the eroding effects of rising prices on their investment returns. The principal and interest payments of real-return bonds are typically adjusted every six months based on changes in the Consumer Price Index (CPI).

While real-return bonds may seem attractive, especially during periods of high inflation, they come with several considerations. The price of these bonds already reflects anticipated inflation, so they only protect against unanticipated inflation increases. In deflationary periods, both principal and interest payments can decrease. Additionally, the tax treatment of real-return bonds can be complex, with investors required to report inflation adjustments as taxable income even before receiving the payments.

For easier access to these securities, some investors might consider a real-return bond ETF. However, the article suggests that real-return bonds, like regular bonds, may provide relatively low returns compared to other investment options. The author recommends focusing on a diversified portfolio of well-established, dividend-paying companies across various economic sectors as a potentially more profitable long-term strategy. While real-return bonds or ETFs can offer some inflation protection, they may not provide the growth potential of dividend-paying stocks.

What’s been your experience with real-return bonds?

With the speculation that inflation will rise in the near future, real-return bonds might seem like a good investment for some investors. What is your opinion? Do real-return bonds belong in a strong portfolio?

This post was originally published in December 2021 and is regularly updated.