The recent rise in inflation expectations has pushed up prices for real-return bonds (RRBs), but the volatility of these inflation-protected securities can work both ways, says Patrick O'Toole, manager of the $61.2-millionRenaissance Canadian Real Return Bond.
"Inflation became much more of a concern this year, with the commodity boom," says O'Toole, vice-president, global fixed income, at Toronto-based CIBC Global Asset Management Inc. As a result, investors have shifted from conventional bonds into this asset class. For the 12 months ended June 30, the fund returned 11.2%, compared with the 12.3% return for the median fund in the Canadian Inflation Protected Fixed Income category. In contrast, the median return in the mainstream Canadian Fixed Income category was 5.4% during the same period.
O'Toole says it is tempting to say that the run for RRBs could be near the end, as real yields have dipped to around 1.4% (which investors receive, on top of the Consumer Price Index inflation rate of about 2.3%).
"People have been happy to buy RRBs, because inflation expectations have been going higher," says O'Toole. "But it's dangerous to time the market," he cautions, adding that RRBs act as an insurance policy against inflationary spikes.
"This is the kind of asset class that you have to commit to for the long run. It's a more volatile asset class than nominal bonds. I always tell people, 'You're not looking at it for one or two years. You should be looking at it for 10 years, plus.'"
RRBs represent a tiny portion of the overall Canadian fixed-income market, and they are also less liquid than regular government bonds. Performance has fluctuated. The asset class did well from 2002 to 2005, but performed poorly in 2006 and 2007.
O'Toole tends to adopt a defensive approach to RRBs, relative to the benchmark DEX RRB Index. This is mainly achieved through the fund's below-average duration (a measure of the sensitivity to interest rate changes), which is 13 years, compared with 16 years for the index.
When building the portfolio, O'Toole determines the outlook for inflation and provincial spreads. He also compares nominal bond yields to RRBs. With yields widening between nominal bonds and RRBs to around 2.5%, O'Toole has favoured the latter. That bet has resulted in an 8.9% return in the year to date, comprised mostly of capital gains.
O'Toole limits single holdings to around 17% of portfolio assets, although he could go as high as 25%. Turnover has been moderate at 28% in 2007 and 25% in 2006.
An Ottawa native, O'Toole has spent almost 20 years in fixed income management, but began his career as an accountant. After graduating from Algonquin College in 1985 with a diploma in business administration, he worked in an accounting capacity at an Ottawa law firm and later for a small software firm. At the same time, he completed the Certified General Accountant designation.
In 1988, O'Toole moved to the finance department of Canada Mortgage and Housing Corp. But he was interested in investing, and within six months he landed a job on the treasury department team that managed CMHC's $1.5-billion mortgage insurance fund.
That gave him a taste of money management. Within a year he took over the portfolio manager's post after his boss had moved on. Between 1993 and 1998, O'Toole managed the fixed income assets in CMHC's $1-billion pension fund. "It was like running a small investment operation. You wore a lot of hats, but learned how everything worked."
In 1998, O'Toole moved to Toronto and joined Canada Trust Investment Management as director, North American fixed income. When TD Bank bought the parent company, he declined an offer to work for TD Asset Management. Instead, he spent a year as director of fixed income at Acuity Investment Management Inc.
In 2002, O'Toole was recruited by Mackenzie Financial Corp. and spent two years on the fixed income team, whose responsibilities included managingMackenzie Sentinel Bond
andMackenzie Sentinel Real Return Bond.
In 2004, O'Toole joined TAL Asset Management, which later became CIBC Global Asset Management. Besides the RRB fund that he took over in September of that year, O'Toole also manages about $3 billion in investment-grade bonds for institutional clients.
O'Toole does not believe that inflation will heat up to the extent it did in the 1970s and 1980s, since central banks are more determined to control inflation and keep inflation expectations out of the system.
"No one really knows how long it this [inflationary spike] will last," he says. "That's why you need a long-term commitment."
andMackenzie Sentinel Real Return Bond.
In 2004, O'Toole joined TAL Asset Management, which later became CIBC Global Asset Management. Besides the RRB fund that he took over in September of that year, O'Toole also manages about $3 billion in investment-grade bonds for institutional clients.
O'Toole does not believe that inflation will heat up to the extent it did in the 1970s and 1980s, since central banks are more determined to control inflation and keep inflation expectations out of the system.
"No one really knows how long it this [inflationary spike] will last," he says. "That's why you need a long-term commitment.":quality(80)/cloudfront-us-east-1.images.arcpublishing.com/morningstar/ZHTKX3QAYCHPXKWRA6SEOUGCK4.png)
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