Since the beginning of September, real return bonds (a.k.a. TIPS, TIIS, inflation indexed bonds) have been tanking. IPE is a (US) TIIS/TIPS ETF, and XRB is a Canadian real return bond ETF. The graphs below show how bad they’re doing versus their nominal government bond counterparts.

BTW, these graphs are from BigCharts. I think BigCharts still provides the best stock charts around.

The reason the bonds are tanking is that people expect a recession and they expect inflation to drop. A big drop in inflation would make the nominal bonds a better deal. We can check the current yields at the Bank of Canada and Bloomberg’s. By subtracting the real yield from the nominal yield we get the market’s expectation for inflation. If actual inflation turns out to be higher than expected, the real return bonds turn out to be better. Note however that, in both Canada and the US, the inflation adjustment is not paid out as interest but added to the face value (principal) of the bond and paid at maturity. This should be reflected in the market price of the bonds, but it doesn’t always appear to be so (as we’ll see below). So, in my opinion, it’s better to hold bonds directly to maturity if you can. Anyway, here’s the data as of September 26, 2008:

Real Return and Nominal Bond Yields

Inflation of only 1.2% for the US?!? That’s bananas! The greater the US’ economic problems, the more the dollar will drop, and the price of imports (including oil) will rise accordingly. I can see inflation lowering from the recent 5.4% due to a recession, but 1.2% seems way too low. The real return bonds seem the better deal, especially in the US.