What Yield Are You Really Earning?

Rising bond yields are giving hope to some income oriented investors that bonds can be a suitable place to earn an income on their capital again. Since 2018, the US 10-Year treasury yield has fallen from a high of just over 3%, all the way down to .50% in the aftermath of the COVID crisis. Currently Treasury yields sit at 1.61%, is this a yield level that will help preserve and grow wealth, and at a minimum maintain your purchasing power?

The answer is unfortunately it depends, but it is important to understand what type of scenario will need to play out to make this 1.61% yield a good deal. One simple hurdle to clear is to look at the “real yield”. The real yield is simply the nominal yield (the 1.61% yield) minus inflation. What is left over is your real yield, or in other words, the yield you are actually getting after inflation chews up your nominal yield. For me this is a minimum hurdle to clear, as it is indicative of whether the yield will maintain the purchasing power of my capital.

For example, if you bought an investment product that had a nominal yield of 2%, and inflation over the next year turned out to be 2%, your real yield is 0%. In real terms, you didn’t actually make any money. How far your money went in buying groceries, gasoline, or other goods, is effectively the same.

What does the real yield on 10-Year Treasury bonds look like right now? Unfortunately, not great. Realized inflation is something that can only be known in hindsight, but currently inflation expectations for the next 5-10 years from many professional forecasters are in the 2-3% range. If we assume the middle of that range (2.5%), with a nominal yield of 1.6% on treasuries, this indicates a potential real yield of -.90%. That is in fact a negative real yield, or in other words, if those inflation figures prove correct, you will be losing 90 bps of purchasing power per annum over the course of your investment at these treasury yield levels.

For reference, in the 2000’s, real treasury yields were regularly 2% or sometimes higher. So why would anyone buy these bonds now? Well, the inflation forecasts may turn out to be wrong, and if inflation comes in much lower, then your realized real yield will turn out to be better than you thought. If there is another crisis of any sort, treasury bonds are one of the few safe investments for investors. Treasury bonds can serve as an instrument to lower your overall portfolio risk. But treasury bonds are typically one of the worst investments when growth and inflation is improving, as investors seek out riskier assets. Bonds are otherwise known as “fixed income”, and in an improving economic environment, you don’t want your income to be fixed, you want it to be improving.

As it pertains to treasury bonds at these yields, it’s important to ask yourself, with the Federal Reserve highly unlikely to restrict monetary policy anytime soon, and the Federal Government looking to continue providing massive fiscal stimulus, would you envision growth and inflation being higher or lower from here? My sense is higher on both fronts, and at a minimum you want to maintain your purchasing power, and treasury bonds in this scenario are a purchasing power destroyer. For treasury bonds to be a good deal here, you need to envision a more dire future in the face of governments worldwide doing everything they can to recover from the COVID crisis.

The real yield as described here can give you a sense of what you are “really” getting from your investment. Inflation can have a pernicious effect on your capital, chipping away at the real value of what you have worked so hard to earn and grow. Consider the real yield as you are looking at your investments, to give you another perspective of how your money is or isn’t working for you.