LOOK OUT FOR THE " REAL RETURN"


A key tool in any fixed-income investor’s toolbox is an understanding of "real yields." A bond’s real yield is its nominal yield minus inflation. In other words, it is the stated, or quoted, yield-to-maturity of a bond minus the current rate of inflation as measured by the consumer price index.

Real yields contain messages about the market that aren’t necessarily evident in nominal rates.

Here are a couple of examples:

Say, for instance, that the nominal yield on a 10-year U.S. Treasury note moves from 8 percent to 6 percent over a period of three years. On the surface, the yield decline might lead some investors to think that rates have fallen too much to be considered for investment.

But those investors might be getting distracted from where their focus should be: on real rates. In this example, if the inflation rate over the three-year period fell to 2 percent from 4 percent, real rates will have held steady at 4 percent. Thus, while it is true that nominal yields became less attractive during the period, real yields became no less attractive.

In another example, consider a situation in which nominal rates rise to 7 percent from 6 percent, but inflation also rises, say to 4 percent from 2 percent. In this case, some investors might be misled into thinking that they have a good investment on their hands based on the rise in nominal yields. But the reality is that it is a less desirable investment (unless the investor has a strong conviction that inflation will fall) because real rates fell from to 3 percent from 4 percent.

So as you can see, it pays to look beyond nominal rates when making a judgment about yields. But what determines real yields and where have real rates been historically?

For perspective, note that for the 10-year U.S. Treasury note, real yields averaged 2.265 percent in the 1960s (a period similar to today, in terms of growth and inflation). But they averages just 0.43 percent in the 1970s (when high inflation cut into nominal yields), 4.96 percent in the 1980s (a period of declining inflation but rising budget deficits) and 3.63 percent in the 1990s (when both inflation and the deficit fell).

The copyright of the article LOOK OUT FOR THE " REAL RETURN" in Fixed Income & Bonds is owned by Naeem Akhtar. Permission to republish LOOK OUT FOR THE " REAL RETURN" in print or online must be granted by the author in writing.

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