The Real Deal on Rates, Yields, and Bonds
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors
Tom Pierce, Head of Fixed Income Manager Research, Wilmington Trust Investment Advisors
TOM PIERCE: The good news for investors going forward is a lot of the damage from rising interest rates has already happened. So, for new investments the bond market today makes a lot more sense than it did back in September of last year when the two-year treasury was yielding as low as 20 basis points.
TONY ROTH: That was Tom Pierce, portfolio manager and head of third-party fixed income, on today’s rising interest rate environment.
TONY ROTH: Welcome to Capital Considerations, the market and economic podcast that’s fully invested in your success. I’m your host, Tony Roth, Chief Investment Officer of Wilmington Trust.
It’s been quite a year so far in the markets and there’s been a lot of focus on the equity markets with the relatively poor year that we’ve had. The NASDAQ is down 20 to 25%. The S&P is down 13-14% year-to-date. And at the same time, the bond market has had probably the worst calendar quarter that it’s had in 30 years.
So, we’re going to focus today on the bond market a bit. We’re going to talk a bit about why the bond market’s been so weak. We’re also going to focus on the very critical concept of real yields today. And we’re not going to get too complicated and too technical. We’ll talk a little bit about real yields and why they’re so critical and what’s happening with them and then ultimately how they relate back to the equity market. And it’s a very timely conversation, we’re really excited to be able to bring this to you.
So let me welcome Tom Pierce. Tom has been an investment professional at Wilmington Trust and M&T Bank for many years, over three decades in fact, and he is currently a portfolio manager for our short-term multimanager fixed income strategy and he’s also our lead analyst, responsible for evaluating and approving third party fixed income investment solutions.
So, Tom, you’re also of course a integral voting member of our investment committee and you play a lot of other key functions for us. Thank you so much for being here today to elucidate and simplify what could be a very difficult topic for many.
TOM PIERCE: Well, thanks for the invite, Tony. Glad to be here.
TONY ROTH: Before we get too deep in today’s conversation because we are talking about specific types of securities, I want to remind the audience that on our Capital Consideration podcasts we are not making specific recommendations to clients to make adjustments in their portfolios or, for that matter, to go out and buy specific bonds. We are talking about the general environment. And I think you’ll find the conversation today quite fascinating.
Tom, I think the place to start is with the basics. So, a bond, just to remind everybody, involves essentially lending money to a borrower and receiving back interest on that loan. And what’s different from – what makes a bond different from a regular loan is that a bond is a publicly issued piece of paper that formalizes the terms of the loan in a very efficient way just through the purchase of that piece of paper in the marketplace. That purchase is effectively an extension of credit or a loan to the issuer of that paper and that paper comes with a predetermined set of coupons, which are interest payments, and that’s sort of how a bond works at the highest level.
So, Tom, when we look at a bond, we see that there are these coupon payments that I’ve mentioned, interest payments. And then ultimately at the end of the bond, there’s a principal payment. And the interest payments, we look at the amount of those payments relative to the principal and that tells us the, if you will, the interest rate or the percentage rate that the bond’s paying. Let’s say we’ve bought a bond for $100, and the coupons are paid quarterly and each quarter the borrower pays a dollar of interest. So that bond would be a 4% yielding bond let’s just say to keep things very simple and we would refer to that as the nominal rate of payment on the bond.
But there’s a more important concept in fact called the real yield on a bond. So, maybe you could start our conversation for us by explaining this idea of real yields. And it’s not an easy concept to understand because it requires a background of inflation and understanding what that is and such
TOM PIERCE: Sure, Tony. So, what’s a real yield? It’s the annualized return a benchmark government bond generates once in inflation is accounted for. And you spoke earlier about nominal bonds. So, nominal yields are the interest rates earned on bonds when the notional principal is a fixed dollar amount, as you’ve already indicated.
And there’s two main factors that determine the level of nominal yields. First, there’s a real yield component, which bond investors require for postponing consumption. And then, secondly, there’s compensation for the expected inflation over the life of the bond. Now technically, there’s also a third piece that is a risk premium for unexpected variations in either of those two components we just mentioned.
Let’s talk about today’s numbers just to give investors some context. So, the nominal ten-year treasury as we speak is yielding 2.90%. The real yield, and an investor can buy today’s real yield via a TIPS. The ten-year treasury inflation protected investment is yielding -12 basis points. So, the differential is a thing we call the breakeven spread and what that represents is what investors believe inflation will be over the life of these ten years. And today, that number’s 3.02. So, the math, so 3.02 for breakeven, nominal is 2.90 and what balances those numbers is the real yield at -12 basis points.
TONY ROTH: So, Tom, you’ve given us a great example that explains these concepts in context of the actual market right now. In order to provide a complementary perspective, another way we might think about to use these actual real numbers.
So, the – if we buy a treasury security today, a ten-year bond, you get back, every year you get back actually $2.90 on a $100 bond. Bonds are actually usually $1,000, right? So, let’s just say $1,000 bond. You get back $29 a year in your account in the form of interest.
But there’s also this inflation rate. And in your example, the market is expecting inflation over the ten years to average around a little over 3%. So, over this period of time the purchasing power of the $2.90 is going to deteriorate because of inflation and inflation will be around 3% a year, so that when you look at the actual return of the bond after inflation, it actually has a negative return after inflation of around I think you said 12 basis points.
So, let’s say you put $1,000 into the bond. You waited ten years. You collected all your interest and then you said, okay, at the beginning when I had $1,000, I could go out and buy X amount of a basket of goods and services. Now, ten years later I want to go out, I want to buy that same basket of goods and services with my $1,000 as augmented by the $29 I received every single year from the interest, but I’ll be able to buy a little bit less because of the inflation rate if, in fact, inflation turns out to be 3% over that period of time. Do I have that all basically right?
TOM PIERCE: Exactly right, Tony. So, when real yields are negative, as they have been for the past two years and four months, what does that imply? It implies that formerly safe nominal treasuries, again this 2.90% today, it implies that investors will lose money in real terms over the life of the security.
As recently as March 8th of this year, Tony, the real yield was a -1.08. We’ve had a material movement upwards in real yields. But the situation was far worse than it is today if you roll the clock back three or four months ago. So much so that it’s encouraged fixed income investors to take additional risks in the form of buying credit-oriented fixed income to pick up some extra yield and it’s moved a lot of people, your classic investor of 60% equities/40% fixed income.
This negative real yield environment over the last two years-four months has caused a lot of investors to go 70% equities and 30% fixed income.
TONY ROTH: Before we get into the dynamics of equities versus fixed income, I want to go back to something that you said over the last couple months, actually, the real yield has increased very quickly. And how has that happened? Because the nominal yield, right, we all watch treasury interest rates because they’re projected on TV all the time and we see that the ten-year used to yield a little over 1% or maybe 1.30 or 1.40 at the beginning of the year and now we’re at 2.90.
So, if the real yield is the nominal yield less the inflation rate, then the nominal yield going up would pull with it the real yield. But at the same time, inflation has skyrocketed this year. So, I would’ve thought that the real yield would’ve actually gone down this year, because even though the nominal yield has gone up by let’s call it 130 or 140 basis points or 1.3 or 1.4%, inflation has just skyrocketed so much this year, since the beginning of the year. Wouldn’t that mean that the real yield would’ve actually gone down because inflation’s gone up much faster than the nominal treasury interest rate?
TOM PIERCE: Well, here’s where it just gets a touch complicated, Tony. We talked about this breakeven number, currently at 3.02. And so, at the beginning of 2021, the breakeven rate was 2%. So, investors were expecting a 2% inflation rate. As investors gravitated around the idea that the Federal Reserve was behind the curve and inflation was picking up, that breakeven rate went up to 2.77% on November 15th of last year. But then, something interesting happened. The breakeven actually declined from that 2.77 level down to 2.40% on February 4th of this year. So, we actually dropped 37 basis points. What’s interesting is what matters is not just what inflation itself is doing month-over-month in real-time, but how investors are perceiving future inflation. So, at the very time, as your question indicated, that inflation was heating up, we actually had a period between November 15th and February 4th where expectations of future inflation actually declined.
TONY ROTH: Tom, let me just interrupt you for a moment to sort of say what you’re saying from a complementary perspective again, which is that when you calculate a real yield, what is the inflation-adjusted yield on this ten-year bond, what matters is not the immediate inflation rate today. So, again, you talked about month-over-month inflation and the fact we got early today that PCE deflator, which is the Fed’s preferred measure of inflation, and it implied around a 5% annual inflation rate given the monthly change of around 0.3% or so.
So, point being that when we look at a ten year bond and we say what is the inflation-adjusted yield or the real yield on that bond, in order to calculate that, we’re using the nominal yield, the one you see on TV, the regular interest rate, and then we’re subtracting from that not the current inflation rate, the month-over-month inflation rate, but we’re subtracting from that what the market is implying the inflation rate will be over the next ten years. And that may be a very different number than what the month-to-month inflation actually is that’s being realized in the economy, because the market’s taking into account things like the Fed’s going to raise rates and slow down the economy over the short period of time, which will help pull inflation back down, and innumerable other factors. Does that all sound like I got that straight?
TOM PIERCE: Precisely. And the implication of the point you just made, Tony, is that it embodies one of the risks for investors buying a TIPS bond. So, even though inflation is high and rising, TIPS actually underperformed in the first quarter of this year. Why? Because the breakeven for a period of time actually fell, but the nominal rate went from this -1.08 to close to positive.
And so, you know, the overly simplistic notion of TIPS is they’re giving you some compensation for inflation, which is true. But there are a couple of other risks embodied in treasury inflation protected securities. Number one, they’re susceptible to interest rate risk and, number two, if you pay too high of a level, an entry level for the bond when real rates are very negative, as real rates adjust upward the principal value of your bond falls because new investors in TIPS are buying a much higher coupon.
Again this area becomes quite tricky and quite complicated. But the bottom line, relating back to what your question was, is that what really matters more are investors’ expectations about the best estimate of future inflation and not necessarily what current inflation is running at.
TONY ROTH: Right. So, just to, again, help translate that is just focusing on the so-called TIPS securities, the treasury inflation protected securities, which we don’t have a particularly large allocation in our portfolios today, even though inflation has been rising and rising, is because what drives the returns or the values as you move forward on those securities is not whether or not inflation is rising, but it’s whether or not inflation turns out to be – to rise more than the market expected at the time that you bought the bond in the first place. So, if you go out and you buy this treasury inflation protected security at any given moment, it’s implying in the so-called breakeven rate that you keep mentioning that inflation is going to be realized over the period of time that you own the bond at a certain rate. And if, in fact, it’s not necessarily in a linear or straight line, but on an average rate over that period of time. And if, in fact, inflation is realized at even a faster rate than what the market was expecting, that’s the situation in which the TIP, all else being equal, is going to really pay off for you. But if inflation is realized at a slower pace than what the market was anticipating, then you will end up underperforming relative to having bought a nominal treasury.
And that’s why buying these treasury inflation protected securities is so complicated, because it’s not just a question of thinking inflation’s going to go up. But it’s relative to what the market’s expecting at the time you buy the bond.
TOM PIERCE: Precisely. And to simplify this for investors, Tony, let’s talk about an ideal condition to buy a TIPS security. So, as an investor, you want real rates that are high enough to begin with that such that in the future they’ll either be stable or falling, number one. And then, number two, as you’ve just stated, ideally, if the expected inflation embodied by the breakeven actually increases while real rates are stable or falling, that’s the scenario in which the TIPS investor wins versus the nominal ten-year investor, ten-year treasury investor.
So, again, you want high enough real rates such that you’re not going to take a principal hit if the entire interest rate structure moves up, number one. And then, number two, you actually want some unexpected inflation. You are buying an insurance premium that protects you from unexpected inflation. So, if investors’ expectations in the future are much higher than they are today, then you win as a TIPS investor.
TONY ROTH: Right. And when you talk about inflation expectations in the future, that’s largely going to be based on what inflation turns out to be between now and that time, whenever that time is that you’re considering let’s say selling a bond.
TOM PIERCE: Precisely.
TONY ROTH: So, let’s bring it back to the main topic of the day, which is so these real rates, which have been negative for quite some time and even though they were close to zero or maybe even slightly positive a couple years ago, if you look over the last decade since the great financial crisis, largely speaking real rates have been negative for the most part over the last decade I believe. Does that sound right?
TOM PIERCE: Well, we’ve had periods where the real rate has averaged 50 basis points or 100 basis points as recently as three years ago, Tony.
TONY ROTH: Explain to everybody then why is it that as an equity investor we have to really take note of this phenomenon that we’re very close to real rates breaking back into positive territory again? Can you take us through that? Because that’s why we’re having this conversation today is because we, in fact, expect the nominal rate to continue to march upward, probably to be 3 to 3.25% before it peaks the cycle. And we think that inflation expectations or these breakeven numbers that we’re talking about are probably pretty close to their peak.
So, as the nominal rate we are positing moves up a little faster than these break evens from here over the next 30 to 90 days, we do expect these real rates to break into positive territory and maybe not just, you know, a couple basis points, but maybe 10, 20, 30 basis points above zero. Why should that impact so dramatically potentially equity investors?
TOM PIERCE: Let’s start with the attractiveness of fixed, nominal fixed income, Tony. So, as you have a positive real yield, that means for all investors that by investing in fixed income, by postponing consumption from today into the future, you’re earning extra money in the form of a positive real yield as a fixed income investor. And because all assets compete with one another and the market has to clear on net yields, the higher the real yield is in bonds, all other things being equal, the more downward pressure that puts on the relative attractiveness of equities.
Simply put, one way to level the playing field is to calculate the earnings yield for equities and then compare that with the real yield in fixed income. That difference, when real yields were negative, as I mentioned earlier, that environment really favored equities. That’s why we heard about the TINA argument for equities. There’s no alternative for other investments, bonds and cash.
TONY ROTH: That was a term we heard for a long time over the last ten years, not just the last two years.
TOM PIERCE: Exactly. And the very low real yields gave rise to that TINA argument because bonds and cash offered such a poor alternative to equities. So, asset allocators added to equities at the margin because these other primary building block asset classes were so unattractive for so long.
We hit a positive real yield for a few hours back on April 20th, just a number of days ago. But we, as I mentioned earlier, we’ve fallen back to a -12 basis points. But there are estimates by some research shops that should the real yield get to even 25 basis points, that is going to send a marginal negative signal for equity ownership and reduce the relative attractiveness of equities.
Now, of course, all different market participants have different real yield levels where equities make less sense relative to fixed income. But I’ve seen at least one research piece recently that’s arguing that 20, even 25 basis points of positive real yield given somewhat elevated equity multiples, I know we’ve come off a little bit in price or forward price earnings multiple for equities. But nonetheless, there are some arguing that relatively small upward changes in real yields are going to be a headwind for equities, you know, whereas negative real rates have been a tailwind for equities for quite a period of time, as you mentioned.
TONY ROTH: So, if I’m an investor and I have the option of putting some money into bonds and rather than in my initial example, coming back at the end of the investment when the bond matures having less purchasing power for the fact of having bought the bond and collected the interest given the way prices change in the world, I actually have more purchasing power. It may not be a lot more, but a little bit. Then, that may be a, an attractive investment for me. And in deciding whether it’s an attractive investment for me, what’s really critical to appreciate, I think, is that the whole environment matters. So, it may not sound particularly appealing to be able to buy with $1,000 maybe after ten years a couple extra Big Macs or something like that, because I collected a few extra pennies after inflation. But if the alternative is investing in equities, which could be quite volatile and we might potentially expect a recession next year, which could push equities into more of a sustained bear market, then once you start thinking in those terms, in other words you take into account the risks which may be elevated for equities that are associated with that kind of investment, then the fact that I’m not losing any money on an after-inflation basis and if I buy a treasury security I’ve got very little credit risk. In other words, it’s like cash in the bank. I don’t have to worry that the government’s not going to be able to pay my principal back at the end of the period. That may start to look like a pretty attractive option for me given the safety and the preservation of the strength or the benefit of my capital.
TOM PIERCE: Exactly. And the higher that real yield moves, the more Big Macs you can buy at the end of your ten-year period.
TONY ROTH: Well, fortunately, I don’t eat Big Macs anymore. But I did eat many Big Macs when I was in my 20s and 30s. So, Tom, with all of that, when you think about what you do in your day-to-day job, where are you seeing actual opportunities in the fixed income market? You do advise us as a member of our investment committee on the attractiveness of stocks versus bonds. But what you do most of the time is you think about what kind of bonds should I be buying for our clients.
So, when you actually look at the bond market, where are you seeing the best opportunity for clients? And how are you deploying capital in the bond market, given that they’re starting to get more attractive, but we’ve had the worst quarter for bonds in 30 or 40 years in the first quarter because interest rates went up so much that it destroyed the capital to a large degree of bonds, relatively speaking.
TOM PIERCE: In the real-world in our MSIS, our multi-strategy income solution, so we compete against a benchmark that’s two years of duration. We entered this year at 0.87 years of duration. So, we had less than half the benchmark duration. Why? Because that real yield, as I mentioned, was a -1. So, at the beginning of the year, we had the defense on the field with respect to interest rates. The investor wasn’t paid enough in terms of a nominal interest rate for the risks that were embodied in the market, particularly as the Federal Reserve recognized that they were behind the curve in fighting inflation.
So, as you’ve already mentioned, you know, rates have materially moved up and now that we’re close to a positive real yield, we’ve been lengthening. We’ve been doing some very selective buying in adding some duration, because as you’ve already mentioned, this was a rout in the first quarter, the worst quarter for bonds since 1980.
Now, the good news for investors going forward is a lot of the damage from rising interest rates has already happened. So, for new investments the bond market today makes a lot more sense than it did at the end of the – at the end of last year or back in September of last year when the two-year treasury was yielding as low as 20 basis points.
So, there are good opportunities. We still like shorter duration instruments and investments. We think one can take a little bit of credit exposure on top of these nominal treasury rates to augment the yield a little more and actually generate a overall portfolio real yield in a safe fashion, as long as we’re buying high quality assets and keeping our durations relatively short.
This is still a very hostile environment for fixed income and the investor strategy is to live to fight another day. To use a baseball analogy, this is not the time to swing for the fences. The batter’s getting low and away or high and inside pitches. So, it’s about sleeping well at night, keeping duration short, and living to fight another day.
TONY ROTH: Well, Tom, this has been a great conversation and I’ve learned a lot. And I think that I can speak for our clients in saying that we are all thrilled that you are on watch for us, thinking about these issues and that you find them to be fascinating and that you’re so good at it, because it’s really one of the more challenging areas of the investment landscape. Some people might even say it’s a little dry. But I don’t think so personally. I think it’s really pretty cool.
But more importantly though, you think it’s cool and you do a, an awesome job for us keeping everything straight for us in our portfolios. So, thank you so much.
And what I want to do is I want to summarize three key takeaways, as I typically do. And the first one, I’m going to actually add a little bit more color to one point that we didn’t talk about per se, which is why have real yields been so low for so long and even before the period two years ago where they moved up a little bit above zero. For the most part, over the last decade they’ve been pretty, they’ve been historically very low, if not negative for most of that period of time.
And so, the first takeaway is that, in fact, these real yields have been negative. But the reason that they’ve been so low is because the environment, the inflation environment has been very subdued, and the Federal Reserve has not been able to get the economy to grow at the speed that it would like to see it grow for the most part over the last 10 or 12 years. It’s grown at a rate of maybe 1.25%-1.50%, so on and so forth. And then we, of course we had the pandemic where the Fed did everything it possibly could in order to keep money flowing in the system to create liquidity and to create velocity or turnover of money in the system.
And for all those reasons, the Fed kept interest rates very, very low in order to try to stimulate the economy, in order to create more wealth in the equity market, etcetera. And that all led to very low real yields and negative real yields for much of the last 10 or 12 years.
The second thing I would say is to remember that when we think about these treasury inflation protected securities what matters most is not what inflation turns out to be over the time that you own the treasury inflation protected bond, but what it turns out to be relative to what the market expected it to be over that period of time when you bought the bond. So, it’s a pretty complicated scenario to figure out how and when to buy these treasury inflation protected securities.
And then lastly is the key point of our conversation, which is that real yields now on the threshold of breaking into positive territory may be meaningfully into positive territory, up to that 25-basis point area or higher, is a real threat to the stock market potentially. It wouldn’t necessarily be if the economy was healthy, if we didn’t have these big exogenous risks going forward like the war in Russia and Ukraine and supply chain problems out of China as they continue to battle with COVID in a much more serious way than we are here.
But because those risks exist, because the overall environment and the outlook for the economy is really quite cloudy and quite compromised, for many investors a certain positive return after inflation with a tremendous amount of safety and security, which is what treasury bonds offer when real yields are positive and then high-grade corporate bonds even more so and high-grade muni bonds even more so can be a quite attractive alternative. And as money ultimately gravitates towards that alternative and comes out of the stock market, that can become a further downward pressure on equities. So, it’s something that we’re taking very much into account as we continue to manage assets for you, all our clients.
So, with that, I’m going to thank you again, Tom, for being here today. It’s been a great conversation.
TOM PIERCE: Thank you, Tony.
TONY ROTH: And I want to remind everybody that you can go to wilmingtontrust.com for a full roundup of our investment ideas and you can subscribe to Capital Considerations on Apple Podcast, Spotify, Stitcher, or your favorite podcast channel for future episodes. Thank you, everybody, for listening today.
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