I know that interest rates negatively correlate with bond yields-to-maturity, but does the lowness of interest rates (for the past several years) fully explain the underperformance of the inflation-protected bond ETFs?

1. BMO Real Return Bond Index ETF enter image description here

  1. I do not quote the performance of iShares Canadian Real Return Bond Index ETF, which also underperforms, and is recommended on p 185 (in the last paragraph of the grey box entitled `The three risks of bond investing'), ETFs for Canadians for Dummies (2013; by Russell Wild and Bryan Borzykowski).
  1. BMO Short Federal Bond Index ETF

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There are some issues with the comparison. The main difference is that the real bond etf contain long term bonds with weighted average term of 19-20 years whereas the other one has a term of 3 years.

It would be better if you compared with a bond fund of similar term such as BMO Long Federal Bond Index ETF

If you did that, you would see that the regular bond fund dramatically outperforms the inflation protected equivalent, and that mismatch basically comes down to inflation expectations.

Massive drop in oil prices in 2015 has caused inflation expectations to come down quickly, making inflation protection less valuable, which is why the inflation protected version underperformed.

A rough rule of thumb is that if interest rates or inflation expectations go up by 0.01%, then the price goes down by roughly 0.01%*term.

Looking at most recent data YTD in March '16, the total return of the inflation protected fund was 0.04% whereas the Long Federal Bond ETF has a 3.01% return. This means in effect that inflation expectations has come down by roughly 3%/19=0.15%. The average investor would consider that a small change but you have to be mindful this is an average across 19 years.

So the key takeaway is if you invest in long term bonds, changes in yields magnify your returns up or down. If you invest in long term inflation-protected bonds, changes in yields OR inflation expectations will magnify your returns up or down.

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