Toronto Star

Tuesday, July 10, 2001

Bonds bring real returns with low risk

When Yale University economist Robert Shiller correctly warned that the U.S. stock bubble would soon burst, he urged us to invest in inflation-adjusted bonds.

Today, more than a year since his book Irrational Exuberance hit the stands, he says he is no less a fan of these little-understood investments.

Returns are lower now than when he first did his research. But he says these bonds are still a bargain compared with the average dividend yield on stocks.

"You can basically triple your yield while cutting your risk," Shiller said in a brief interview yesterday. "It sounds pretty good to me."

Many investors disregard the value of corporate dividends when they buy stocks or mutual funds. After all, dividend yields average only about 1.3 per cent in New York and 1.5 per cent in Toronto.

We have all been conditioned by the huge success of others who have generally been able to buy and sell stocks at a profit over the past 20 years.

Shiller has taken a much longer view of investment history, though. History has a habit of shattering commonly revered myths, such as that old saw that stocks always outperform bonds.

The truth is that bonds have actually beaten stocks over extended periods in the past century and we could well have entered one of those periods again.

Stocks are still highly valued relative to the profits that corporations managed to earn during the past decade, Shiller has calculated.

We may or may not see profits improve enough over the next 10 years to bring the relationship between prices and profits back to the historic average.

"Stocks . . . are residual claims on corporate cash flow, available to stockholders only after everyone else has been paid. Stocks are, therefore, by their very definition, risky," Shiller wrote.

There is also some risk with standard government bonds that pay a fixed coupon rate every six months and guarantee your return of capital after one to 30 years.

That is the risk that rising prices will erode the value of the bond coupons and your capital more than expected. When inflation and interest rise, bonds bought earlier fall in price.

Inflation-indexed bonds, or real return bonds as they are called in Canada, remove that inflation risk. They guarantee a yield on your investment that will always be greater than inflation, no matter how high inflation goes.

Issuers of the bonds do this by increasing both the value of six-month coupons and the capital returned at maturity to keep pace with the consumer price index.

Big pension plans with long-term liabilities love real return bonds, or RRBs. The Ontario Teachers' Pension Plan has locked up a major portion of the market in Canada, and is encouraging bond issuers to bring more RRBs to market. Shiller said that since the updated version of his book came out, the U.S. Treasury is using television spots to advertise such bonds to consumers.

In Canada, not many consumers know about or own such bonds.

Roger Quick, a fixed-income analyst with Scotia Capital in Toronto, said the bonds are an appropriate choice for retirement savers with a long time horizon.

Bonds do fluctuate in price. So, unless you can make a well-educated guess about where inflation and interest rates are headed, you are best to hold them to maturity to earn the yield quoted to you on the day you make your purchase.

Quick supplied data on the real yield, or yield on top of inflation, offered by one series of federal RRBs since April, 1996 - the high point over that entire period.

Annual yields for large wholesale purchases have fallen from 5 per cent on top of inflation since then, to 3.57 per cent as of late yesterday. But Quick said that is still a reasonable yield.

"These bonds are certainly not over-valued," he argued.

The federal government has only three real-return issues, with maturity dates in 2021, 2026 and 2031. The government periodically will make new supplies available.

But investors need not buy a bond with such a far away maturity.

Securities dealers will separate coupon payments from principal payments and sell them as two separate instruments called strips and zeroes.

So you can buy a strip -- the usual minimum is $5,000 -- from an RRB that will pay you a sum of money four, six or whatever years away. The cost will be less than what you will receive at the end of the term. Prices are discounted to produce whatever is market yield on that particular day.

If you are interested, you can deal through either a full-service or discount broker.

By fall, a new electronic bond trading network called CanDeal will make it quicker to shop for the best price.