Real Yields Positive (again)

Real yields are positive again after the pandemic where they were negative with rates at practically zero.

Most real assets have negative expected returns in this economic environment.

So why take on riskier assets when real yields on risk free assets are positive?

Risk free rates down from highs in mid NOV.

Good time to buy bonds? When rates are at highs and prices are at discount (inverse relationship) buying long term “non-callable” bonds. Then as rates come down, the prices go up plus you should have received the highest Yield to Maturity. Yield to Maturity factors in the total yield which is the coupon plus the capital gains (or loss but not in this case) of the bond.

To calculate the real yield, we simply take the current 10-year Treasury yield and subtract the current 10-year inflation expectations as measured by the Treasury Inflation Protected Security (TIPS) breakeven spread.

TIPS. What are they?

Treasury inflation-protected securities (TIPS) are a type of Treasury security issued by the U.S. government and are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. They are issued in 5, 10, or 30 years and are considered a low-risk investment because the U.S. government backs them. At maturity, TIPs return the adjusted principal or the original principal, whichever is greater.

Their rates are fixed but their principal is adjusted every six months so their yields change. Their real yields were negative during mid 2020 – April 2022.

As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) in order to maintain real value.

Principal value of TIPS rises as inflation rises while the interest payment varies with the adjusted principal value of the bond.

Principal amount is protected since investors will never receive less than the originally invested principal, if they hold to maturity.

TIPS should perform better in a rising interest rate environment than conventional Treasury bonds because their inflation adjustments provide better price protection, but only when rates are rising as a result of increasing inflation.

The issue is that longer-term TIPS also suffer from interest-rate risk, or duration.

If inflation is going to remain high for the next couple years but rates are going to peak in early 2023 (modest recession), longer-duration TIPS should outperform.