Real Return Bonds

As of the end of February 2010, the Government of Canada had issued and outstanding 21 series of real return bonds. All of the bonds were issued with a 30-year term to maturity.  Real return bonds are a direct, unsecured, unconditional obligation of the Government of Canada. The bonds of a series cannot be called for redemption by the Government of Canada prior to their maturity date and each bond has a nominal principal amount of $1,000.00.

The bonds pay interest on the bond principal that is adjusted in relation to the Consumer Price Index (CPI) for Canada. Interest on the bonds consist of both an inflation compensation component (Inflation Compensation), calculated based on the principal and payable at maturity, and the regular coupon interest payment, which is calculated on the principal and the Inflation Compensation. The coupon interest is payable in semi-annual installments on the dates specified for each series of bonds in each year.

Note: Coupon Interest is calculated by multiplying one-half of the specific annual coupon rate for the relevant series of bonds by the sum of the principal and the Inflation Compensation accrued from the date the first bond of the series was issued (the Original Issue Date) to the relevant Coupon Payment Date.

At maturity, in addition to Coupon Interest payable, a final payment equal to the sum of Inflation Compensation accrued from the Original Issue Date to Maturity (whether positive or negative!) and principal will also be made.

The fundamental difference between the Canadian real return bonds and similar bonds issued by the U.S. Treasury, called Treasury Inflation-Protected Securities (TIPS), is that the U.S. securities have a floor on the Inflation Compensation mechanism, such that in the event of deflation, the principal cannot decline below the original issue amount. Canadian real return bonds do not have a similar mechanism and, as a result, the real return bonds could return an amount lower than the original issue amount. This possible outcome is highlighted in the Bank of Canada’s discussion of the income tax treatment of both the Coupon Interest Payments and the Inflation Compensation Payment, upon maturity.

Note: In the following section we have copied the Bank of Canada’s discussion of the income tax treatment for taxable Canadian investors for your reference. The text was copied from the Bank’s November 25, 1994 discussion paper on real return bonds. This quote can be viewed in greater detail at the Bank’s website @ (https://www.bank-banque-canada.ca/en/markets/bonds-e.html):

CANADIAN FEDERAL INCOME TAX CONSIDERATIONS

The following general summary fairly describes the principal Canadian federal income tax considerations generally applicable to purchasers of Bonds, pursuant to an offering of Bonds by the Government of Canada, who are residents of Canada for the purposes of the Income Tax Act (Canada) (the “Act”), to whom the Bonds constitute capital property for the purposes of the Act and who are subject to tax under Part I of the Act and also describes the Canadian federal withholding tax consequences for purchasers of Bonds, pursuant to an offering of Bonds by the Government of Canada, who are non-residents of Canada for purposes of the Act.

This summary is based upon the current provisions of the Act and the regulations there under (the “Regulations”) in force as of the date here of, the current published administrative and assessing policies of Revenue Canada and upon all proposals (the “Draft Amendments”) to amend the Act and the Regulations released by the Minister of Finance (Canada) prior to the date here of. This summary assumes that the Draft Amendments will been acted in a form consistent with the following summary; however, no assurance can begiven that the Draft Amendments will be enacted in such form. This summary is not exhaustive of all possible Canadian federal income tax consequences and, moreover, does not take into account or anticipate any

Provincial, territorial or foreign income tax considerations, which considerations may differ significantly from those discussed herein. Tax legislation in certain of the provinces may require amendment so that Bond owners will be afforded similar provincial tax treatment to that described in this summary.

This summary is of a general nature only and it is not intended to be, nor should it be construed to be, legal or tax advice to any prospective purchaser of bonds and no representation with respect to the Canadian federal income tax consequences to any such purchaser is made herein. Prospective purchasers of bonds should consult their own advisers with respect to their individual circumstances. This summary does not apply to persons acquiring bonds otherwise than pursuant to an offering of the bonds made by the Government of Canada.

Taxation of Coupon Interest

The normal rules, which require certain taxpayers to include interest in income on an accrual basis, will not apply to Coupon Interest. Rather, a bond owner will be required to include in income for each taxation year in which the bond owner owned a bond any Coupon Interest, which has been received or become receivable in that taxation year, depending upon the method regularly followed by the bond owner.

A bond owner will be required to include in income the full amount of Coupon Interest paid on a Coupon Payment Date, being the interest that has accrued since the immediately preceding Coupon Payment Date for the relevant series of bonds; however, to the extent that Coupon Interest has accrued prior to the date of issuance of bonds, a deduction will be available to the bond owner. Any amount, which is so deductible, must be deducted in computing the adjusted cost base of the bond to the bond owner.

Taxation of Inflation Compensation

The Income Tax Act and the Draft Amendments provide that a bond owner is required to include in computing income for a taxation year, as interest, the amount by which Inflation Compensation has increased for any inflation adjustment period that ends in such taxation year and during which the bond owner owned the bond. The amount of any such increase required to be included in a bond owner’s income at any time shall be added to the adjusted cost base of the bond to the bond owner.

The Act and the Draft Amendments further provide that the amount by which accrued Inflation Compensation has decreased for any inflation adjustment period that ends in a taxation year of a bond owner and during which such bond owner owned the bond shall be deductible in computing the income of the bond owner for such year. The amount of any such decrease permitted to be deducted in computing the income of a bond owner at any time shall be deducted from the adjusted cost base of the bond to the bond owner.

For these purposes, the first inflation adjustment period for a series of bonds acquired in an offering by the Government of Canada will be the period commencing on the date of issuance of such bonds. Each subsequent inflation adjustment period will commence on a Coupon Payment Date for such series. An inflation adjustment period will end on the earlier of the next Coupon Payment Date for such series and the date of disposition of the bond.

Disposition of a Bond

On the disposition or a deemed disposition of a bond, the bond owner will realize a capital gain (or capital loss) to the extent that the proceeds of disposition (net of any costs of disposition) exceed (or are exceeded by) the adjusted cost base of the bond to the bond owner. The tax treatment of changes in the Inflation Compensation for inflation adjustment periods ending in the taxation year of disposition is described above under the heading “Taxation of Inflation Compensation.”

Pursuant to the provisions of the Act, any accrued Coupon Interest on a bond to the date of disposition of such bond must be included in the income of the bond owner. To the extent that the amount received on the disposition of a bond by the bond owner in respect of the Coupon Interest is less than the accrued Coupon Interest on such bond, the bond owner may be entitled to a deduction.

Considerations before purchasing

Before investing in real return bonds, you should consider the following risks associated with these types of bonds:

1. Real return bonds are subject to similar risks and influences as regular long-dated bonds, such as interest rate risk, re-investment risk, market pricing risk, etc.
2. The Inflation Compensation component is included or deducted in the investor’s taxable income for each adjustment period even though it is not paid until the bond’s maturity date.
3. In a deflationary environment, the Inflation Compensation can decline creating a deduction from the investor’s taxable income. If deflationary forces persist, this may result in a capital loss at maturity.
4. Price Variability. The real return bond pricing is subject to changes in yields and fluctuations in the CPI. Real yields may vary depending on economic developments and the supply and demand for each series.
5. Indexing Lag. The calculation of the Index Ratio incorporates an approximate three-month lag, which may have an impact on the trading price of a series of bonds, particularly during periods of significant changes (positive and negative) in the CPI.
6. Cash Flow Variability. Coupon Interest on each series of bonds varies depending upon changes in the relevant Index Ratio, which incorporates CPI data. As a result, the amount of Coupon Interest may rise or fall from one Coupon Payment Date to the next and such variations may be material during periods of significant changes in CPI.