The modified Fisher equation (1) shows that the required return (or yield-to-maturity YTM) on a conventional bond consists of three parts: the real return rate, the expected inflation rate over the life of the bond and the IRP. The last element compensates the investor for the risk of having a wrong expectation of inflation. In the case of the RRB, since the investors do not assume this risk, the required return only contains the first two parts.
E(Rnominal) = Yreal + E(I) + IRP (1) E(Rreal) = Yreal + E(I) (2)
Where :
E(Rnominal) = expected nominal return on nominal return bond
E(Rreal) = expected nominal return on real return bond Yreal = real interest rate E(I) = expected inflation IRP = inflation risk premium
Siegel and Waring (2004) explain the utility for an institutional investor with a liability linked or partly linked to inflation of combining real return bonds and nominal bonds to minimize surplus (asset minus liabilities) risk. Nowadays, the expected return of such a portfolio is relatively low. Consequently, adding value is necessary to achieve the required rate of return of the actuarial evaluations. Tactical allocation between nominal and real return bonds can be a source of added value. In that manner, the amount of money that an investor is expected to leave on the table (IRP) by purchasing an RRB instead of a conventional bond needs to be quantified. We contribute to this field of research along three dimensions. First, we provide a time-series estimation of the IRP figure priced in the Canadian bond market. Second, we formally test for the relationship between the IRP and the subsequent difference of returns between RRBs and conventional bonds. Finally, we implement different systematic decision rules for the allocation between real and conventional bonds. We find that the IRP provides significant economic benefits when tactically moving money from real to conventional bonds. Read the full paper here.
Natacha Lemaire, M.SC., CFA, is adviser, investment Policy advising, Caisse de dépôt et placement du Québec, Montreal. Jean-François Plante, M.SC., CFA, is director, investments, Caisse de dépôt et placement du Québec, Montreal.