A bond’s real return = The bond’s quoted yield – the current rate of inflation.
When people quote the interest rate on bonds or any other type of investment, they are almost always referring to the nominal rate of return. The nominal rate of return calculates the percentage gain or loss in dollars. However, a dollar today does not have the same value, as a dollar ten years ago. As an investor, what matters to you at the end of the day is how much you earn after inflation, which is otherwise known as your real return.
To help understand why looking at a bond’s real return is important lets take a look at an example.
Lets say you invested in a 1 year US Treasury paying 4% and held it until maturity. During that year inflation was running at 3% per year. At the end of the year you invested the same amount of money in a new 1 year treasury which paid 3% and held it to maturity as well. During that year inflation was running at 1%.
If you were simply considering a bond’s quoted/nominal yield, then you may think that you were getting a better return on your money when the 1 Year Treasury was paying 4% than when the 1 year Treasury was paying 3%.
However, when looking at the difference in real yields between the two bonds, you can see that your real return is actually higher in the 3% bond.
Real Return on the 4% 1 Year Treasury with inflation at 3%: 4% Yield – 3% inflation = 1% Real Return.
Real Return on the 3% 1 Year Treasury with inflation at 1%: 3% Yield – 1% inflation = 2% Real Return.
As you can see from the example above, looking at the real return is important when considering how attractive your actual returns (after taking into account loss of purchasing power due to inflation) are at different points in time.
You can look at the real return for any type and maturity of bond. For US Treasuries, which are free from default risk, the real yield gives you a picture of:
If you are looking at the real return for other types of bonds, like corporate bonds for instance, the real return is going to include some additional yield for credit risk and the uncertainty surrounding the future credit risk of a bond. Other factors like the extra yield that investors will demand for investing in illiquid bonds may play a role as well.
Investors will often look at the fluctuations in real yields over time. The real yield of US Treasuries gives you the “cleanest” picture of real yields. The interest rate paid on a TIPS, not including adjustments to principal (which accounts for inflation), is equivalent to the real yield, so looking at a chart of TIPS yield (which you can find on the St. Louis Fed’s site here) is the easiest way to evaluate real treasury yields.
During normal economic conditions real treasury yields are much more stable than nominal interest rates. As you can see from the chart above however, since the financial crisis real yields have been anything but stable, and have actually gone negative.
Real yields on treasuries are below historical averages because there are buyers that are investing in Treasuries with returns not being their main objective. Particularly, the Federal Reserve has been a major buyer, and investors looking for a super safe place to put their money have been buyers following the financial crisis. As demand for capital starts to pick up, and investors start to become less risk averse real interest rates should start to move back towards historical norms. This could provide investors with an early indication that the economy is recovering, giving the astute investor the opportunity for profit.
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For the definition and explanation of more bond related words visit the Learn Bonds glossary where we give the meaning of many additional terms.