Why MoneyGeek's Portfolios Don't Include XRB or ZRR

Last update on July 3, 2017.

Image Credit: ahmetemre / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also explain why I’ve decided not to include real return bonds in MoneyGeek’s model portfolios.

 

June Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of June 2017 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Slightly Aggressive

-3.1%

+19.4%

+77.4%

Balanced

-2.9%

+17.2%

+64.5%

Slightly Conservative

-2.6%

+14.8%

+52.3%

Moderately Conservative

-2.3%

+12.3%

+40.7%

Very Conservative

-2.0%

+10.0%

+29.7%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

-2.7%

+13.7%

+56.0%

TD Comfort Aggressive Growth

-2.5%

+10.7%

+43.4%

CIBC Managed Aggressive Growth

-2.9%

+11.6%

+48.6%

Canadian Couch Potato Aggressive

-2.4%

+16.8%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free regular membership.

The Regular portfolios underperformed their competitors in June. While the value investing components of the portfolio held up OK, both oil and gas stocks, and gold declined by 6.6% and 6.3% respectively. I talk enough about oil and gas stocks in other articles, so let me briefly talk about gold.

Gold prices held relatively steady for most of June. On the morning of the 25th, however, gold suddenly dropped by $17/oz (roughly 1.4%) within minutes, before bouncing back somewhat. Some people think the sudden drop in prices were the result of a trader’s mistake - i.e. a trader may have sent a bigger sell order than he/she intended. But no one really knows for sure.

With the absence of any significantly bad economic news, it’s no surprise that gold prices have gone nowhere since I introduced it to MoneyGeek’s portfolios. What’s more, if the global economy continues to chug along at the current growth trajectory, I expect gold prices to either stagnate or even decline.

Given the poor outlook of gold during good economic times, you may wonder if MoneyGeek’s portfolios should include real return bonds instead of gold. Real return bonds are bonds issued by the federal government of Canada, where their coupons (regular payments) move with inflation. In other words, if inflation goes up, the bond pays more. There are two ETFs in Canada that offer real return bonds that I know of: iShares Canadian Real Return Bond Index ETF (Ticker: XRB) and the BMO Real Return Bond Index ETF (Ticker: ZRR).

At first glance, real return bonds are the perfect investment for safety conscious investors. As with other types of bonds, real return bonds generally do well when stock markets crash, as investors flock to bonds in such times. But unlike other bonds, real return bonds are theoretically protected from inflation. Unlike gold, real return bonds continue to generate positive income during good economic times.

However, that doesn’t mean that real return bonds are completely safe. In particular, a real return bond’s value can decline if real interest rates rise.

A bond’s real interest rate is the bond’s nominal interest rate minus inflation. For example, let’s say you bought a bond for $1000 that pays $50/year. Then, the nominal interest rate is 50/1000 = 5%. Now, let’s also say that the rate of inflation when you bought the bond was about 2%. Then, the real interest rate is 5 - 2 = 3% per year.

If you buy a real return bond and hold it until maturity, you will more or less earn the real interest rate. For example, if you buy a real return bond with a real interest rate of 3%, and if inflation averages 4% while you hold the bond, then you’ll receive 3 + 4 = 7% per year in nominal terms (i.e. $70/year on a $1,000 bond). If inflation averages 1% instead, you’ll receive 3 + 1 = 4% per year in nominal terms instead. Therefore, if your intention is to hold a real return bond until maturity, the bond can work well in your favour.

However, it’s still possible to lose money on your real return bond before the bond matures. In my free book, I explained that bond prices go down if interest rates rise, and vice versa. Real return bonds act the same way in reaction to the movement of real interest rates.

Unfortunately, real interest rates tend to rise when inflation runs high. This is true historically, as you can see from the following chart.

OB-QC128_LongTe_K_20111013104251.jpg

Image credit: Wall Street Journal

This phenomena occurs because when inflation is high, central banks tend to hike interest rates to levels that are high, even relative to inflation, in order to bring inflation down. The situation today of course is the reverse, which is why the average real interest rate of bonds in XRB is a mere 0.46% per year, far below the historical average.

Given the historically low real interest rate today, I don’t think there’s a lot of room for real interest rates to go down further. On the other hand, I think there’s a lot of room for rates to go up.

If real interest rates do move up, the price of real return bonds can decline quite substantially. Most real return bonds have long maturities, which have led both XRB and ZRR to have average durations of more than 15 years. This means that if real interest rates rise by 1%, then we can expect both ETFs to lose roughly 15% each.

Because of these dynamics, real return bonds actually do a less than perfect job of protecting its holder from inflation. Since higher inflation remains one potential scenario that I want to guard against, I have opted not to include either XRB or ZRR in MoneyGeek’s portfolios, at least for now.

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