Is now a good time to buy TIPS or RRBs? As Mr. Brewster says such vehicles “can help one’s portfolio keep pace with the cost of living, however….as with any investment, it is important not to overpay for [them] as doing so can offset the benefits of the inflation protection.” And as we shall see below, RRBs don’t appear to be such great bargains right now.

“The best measure by which to judge the value of an RRB [or TIPS] is…the break-even inflation rate (BER),” adds Mr. Brewster. “The BER is the difference between the yield on a nominal Government of Canada bond and the real yield (the yield less inflation) on an equivalent RRB.”

Let’s illustrate with an example. According to Bank of Canada data, the real yield on long-term RRBs is 1.53% as of Jan. 5. The nominal yield on long-term Government of Canada benchmark bonds is 4.08% as of Jan. 5. The difference (4.08%-1.53%) is 2.55% and represents the current BER.

Now, if the actual annual inflation rate until the bonds mature is less than 2.55%, then the nominal bonds will be the better investment. Their real return will be higher than the 1.53% currently paid on the RRB. Conversely, if the annual inflation rate ends up higher than 2.55%, the RRB would be better since its real return would be higher.

So, if you believe long-run inflation will exceed 2.55% per year, you will want to buy RRBs at this time. If not, the nominal bonds would be better to buy.

Will annual inflation be under or over 2.55% over the long run? I personally believe that the Bank of Canada will continue to adhere to its target of 1% to 3% annual inflation. This would make RRBs slightly overvalued relative to the mid-point of the central bank’s target range. So I would not necessarily be a long-term buyer at these prices.

The time to buy RRBs, in my opinion, is when the BER dips toward the lower boundary of the Bank of Canada’s target range. In Chart 1 below showing the BER for the 2021 maturity (provided via Mr. Brewster), you can see that the time to buy RRBs was in late 2008 or early 2009. Back then, fears of deflation were rampant, which dragged the BER down to 1%.

The price of the iShares Canadian DEX Real Return Bond Index ETF (XRB) has accordingly followed the BER higher since the trough a year ago. As you can see in Chart 2 below (Google graph), it has risen from $18 to $20.5, an increase of about 14% (in general, the price of XRB appears to track the BER).

Inflationary fears could still continue to mount as 2010 progresses and thus cause more appreciation in XRB, so I would continue holding the ETF or RRBs if you already own them (disclosure: I own XRB). However, at some point, the central banks will begin to withdraw stimulus from the economy and cap inflationary expectations (and, in turn, price gains in XRB).

Chart 1: Breakeven rate of inflation of 2021 maturity (1991 to 2009)

Chart 2:  Price Trend in iShares Real Return Bond ETF (XRB)

Appendix 1: How Do Real Return Bonds (RRBs) Work?

RRBs are identical to traditional bonds in most ways, except that their cash flows keep pace with the cost of living. Inflation, as measured by the Consumer Price Index (CPI), is represented by the RRB’s Index Ratio, which tracks changes in inflation since the bond’s issuance. To keep pace with inflation, the Real Face Value of the RRB is multiplied by the continuously updated Index Ratio to determine the Nominal (current) Face Value. The semi-annual coupon payments are based on the Nominal Face Value. For example, suppose an investor holds $10,000 Real Face Value of an RRB. If the current Index Ratio is 1.35506, the Nominal Face Value today would be $10,000 x 1.35506 = $13,550.60. If the RRB has a semi-annual coupon rate of 4.25% the coupon payment would be as follows: Nominal Face Value x (Coupon/2) = Interest Paid Out $13,550.60 x (4.25%/2) = $287.95 Note that the coupon rate does not change, but as the Real Face Value is multiplied by the Index Ratio, the coupon payment fluctuates with inflation. At maturity the Nominal Face Value is returned to the bondholder. So both the coupon payments and the principal repayment fluctuate with inflation. While the calculations may appear complicated, what matters most is that inflation protection is achieved.

But making salespeople care more about relationships than revenues requires a compensation scheme that supports this behaviour. Osing recommends companies ask customers to rate their salespeople on a handful of factors, such as problem solving and service, on a scale from 1 to 5. Those results should have a significant impact on pay. “The first time sales reps get their customer report cards, they go into their cave. They’re hurt. They’re mad. The good news is they know where they are and they start to listen now to what the customer is saying. Over time they work harder to get better marks,” he says.

Osing says sales reps at Telus were compensated 50% on customer perception and 50% on revenues. Reps with high marks were also the ones with the most sales.

Sure, the U.S. CPI hit an annual growth rate of 5.7% in July. But the main cause of the inflation surge, soaring oil prices, is beating a hasty retreat — as are prices for commodities and foodstuffs (other important contributors). Even rising import prices are going into remission thanks to the recent rise in the U.S. dollar.

Look at how financial markets yawned when the CPI figures came out. Futures on federal fund rates barely moved. Yields on inflation-protected Treasuries (TIPs) fell (the spread of the 10-year TIPs yield over regular 10-year Treasuries yield — a proxy for inflationary expectations — has now collapsed from 2.57% to 2.22% in a little over a month).

Retail sales volumes have been dropping despite the tax rebates issued by the U.S. government. Job losses, falling house prices, and credit rationing are taking their toll. With most rebate cheques already disbursed, retailers are likely to pick up the pace of price discounting in the months ahead, says BMO Financial.

The forces of recession do indeed appear to be in the ascendancy. Japan’s economy contracted at an annual rate of 2.4% in the second quarter, its worst performance in seven years. The eurozone economy shrank in the second quarter, the first contraction since the launch of the euro in 1999. The Reuters-Jefferies CRB index has fallen almost 20 per cent since the peak in July.

The Fed’s latest survey of lending officers shows continuing tightening of credit standards. In the three months ended June 30, total bank credit contracted at an annual rate of 3.7% — the biggest drop in 60 years.

A slowdown in loans coincides with a slowdown in bank deposits — which in turn slows growth in the M2 definition of money supply. M2 had annualized growth of only 2.5% in the three months ended July, compared to 13.2% in the three months ended March, 2008. If inflation is “always and everywhere a monetary phenomenon,” as the great economist Milton Friedman said, then a deceleration in the money supply implies a deceleration in inflation.

In fact, the M2 slowdown implies a drop in economic growth when inflation is taken into consideration. The real money supply (adjusted by consumer price inflation) has contracted at an annual rate of 7.3% in the three months to July 30, “the sharpest three-month contraction since early 1980,” according to Northern Trust.