Real return bonds — a security that offers holders inflation protection for both the interest and principal components — is the newest fixed income asset class to make its way into a structured product.
Connor, Clark & Lunn Capital Markets Inc. — a unit of Vancouver-headquartered Connor Clark & Lunn Financial Group — is behind the recently filed Connor, Clark & Lunn Real Return Income Fund. The fund has a straightforward objective — to generate monthly tax efficient distributions — through investing most of the proceeds from the issue in AAA-rated real return bonds.
In the United States, real return bonds are known as U.S. Treasury Inflation Protected Securities or TIPS.
(With TIPS, the principal and interest is adjusted with reference to inflation: The amount of interest paid depends on the rate of inflation while the par value of the bond rises in lockstep with the rate of inflation.)
The rest of the proceeds will be invested in a slew of other fixed income assets. It’s expected that not many of the assets will come from Canadian issuers. The local real return market is home to about $25-billion of issuance. The federal government is the biggest issuer though a number of corporates — including 407-ETR International — have also raised capital through this form.
With a dose of leverage — the issuer is allowed to borrow 1.6 times the amount that it raises from the offering — the plan is to generate returns of about 5.50%. (Naturally, without leverage the return would be substantially lower. Leverage on this offering is bigger than on a normal pool of income funds.)
However, the issuer makes it clear that the cash distributions are not fixed and may vary from month to month. But when they are made, the cash distributions will be tax efficient thanks to a forward agreement that converts regular income to capital gain.
The offering is the first structured product offering that has incorporated real return bonds.
Western Asset Management, a unit of Legg Mason, will be the fund’s investment advisor.
Naturally, there are fees associated for doing all of this. There is an annual 120 basis points management fee; there is 30 basis points servicing fee paid to the brokers plus a 50 basis points fee for having the forward swap agreement swap.
As well, there are the annual operating expenses of the trust. Those costs — all of which are paid annually — come after the initial 5% agents fee plus new issue expenses, which will be capped at 1.50% of gross proceeds.
Given that most of the investments will be in U.S. dollars, the manager will be required to hedge back to Canadian dollars.
So what’s the magic of real return bonds?
For starters they are a growing asset class with worldwide issuance being around US$600-billion. Accordingly, there are lots of opportunities to buy assets and over varying maturities.
In contrast, the local market has received about $24-billion of issuance, all of it with at least 15 years to maturity. Secondly, in world of an uncertain equity markets, this product provides inflation protection.
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The CC&L offering continues something of a trend among structured product issuers. The offering is another example of a U.S. fixed income asset class making its way north of the border. Over the last few years, offerings have been based on high yield securities (Skylon Capital has a number of such products with Pimco, the world’s largest fixed income manager, being the advisor); on preferred securities (a debt offering that gives the issuer considerable flexibility); on mortgage-backed securities (Sentry Select, for instance, has done such deals); on non-investment grade corporate loans (Fairway, First Trust/Highland Capital have raised capital to invest in such an asset class); and on credit default swaps (ROC has completed three deals — which raised about $650-million — which provide investors with a return based off a pool of loans.)
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CC&L’s offering is also a rare example of a structured product that already exists in the world of mutual funds. (Of late the tendency has been for mutual fund managers to copy products that already exist in the world of structured products.)
TD Mutual Funds has, for instance, offered a Real Return Bond since 2001. The fund is offered as a way of providing a regular level of interest income that is hedged against inflation. The manager achieves that objective by investing primarily in Canadian government guaranteed real return bonds. The manager is also allowed to invest in real return bonds issued by the governments of foreign countries. Until the 30% foreign limit was changed, the manager was limited to having 30% of the assets invested in foreign issuers.
On its Web site, TD says that the fund “may be suitable for medium to long-term investors who are concerned about the long-term effects of inflation, can accept some interest rate risk, achieve moderate capital growth and are contributing to the income component of a diversified portfolio. Investors in this Fund should be willing to accept a low to moderate level of risk.”
At the end of May, the fund has assets of $1.868-billion; had a management expense ratio of 1.63% and over the past year had posted a return of 6.3%.
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In October, 2003, Mackenzie Financial launched its Mackenzie Sentinel Real Return Bond Fund. It has assets of $195.45-million and a management expense ratio of 1.6%. Since last October, two other fund managers — Altamira and Dynamic — have also weighed in. Dynamic’s Fund has $40.94-million of assets and a MER of 2.48% while Altamira’s Inflation Adjusted Bond Fund has raised $3.41-million.
By Barry Critchley
Source: National Post
Photo credit: KJGarbutt via VisualHunt.com / CC BY
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