Bonds Paying Less Than Inflation

Bonds, Investing & Retiring

What does it mean when a bond has a negative return? It simply means that a bond is worth less at maturity than its value at purchase.

As strange as it may sound, negative nominal (face value) bond yields have occurred in the past. Investors can accept such a rate to maintain a low risk factor compared to equities, and potentially to make money if the rates are expected to plunge even further into negative territory.

We are not dealing with negative nominal bond returns in the U.S. right now, but we are experiencing negative real bond returns. Real returns are calculated by subtracting the rate of inflation from the bond yield. In the case of ten-year Treasuries earlier in April 2016, the yield was 1.72%, while the core Consumer Price Index (CPI) was 2.3%, resulting in a real yield of -0.58%.

In essence, the increase in the value of your bonds does not keep up with the cost of living at the moment.

Can you accept a negative real rate on your bond investments? The answer depends on several personal factors as well as the economy at large.

At the personal level, your risk tolerance and needs play a role. If you are young and have plenty of time to recover, you would probably be better off putting your money in equities. Older investors that have limited time to recoup a loss may prefer the relative safety of bonds even if the rates are low — at least they will be assured of getting that low rate back with Treasuries.

Lower tolerance for risk also drives investors toward bonds, even if it doesn’t match their needs. When it seems that all is crumbling, a minor loss to inflation may be preferable to a major one in equities.

That concept brings us to the overall economic picture, starting with expectations for inflation moving forward. The Federal Reserve is currently dealing with conflicting goals in trying to control the inflation rate at around 2% while bringing interest rates back from the near zero levels that they have held for years. Raising interest rates should keep inflation down, raising real bond yields in the process — but with the economy in such an odd state of low interest rates and low inflation, economic predictions are becoming less reliable.

Investors must also consider the rate and liquidity of the low-risk alternatives. How does your negative real return on bonds compare to other cash alternatives like money market funds or CDs? How quickly will you need access to your cash?

Finally, there is the issue of supply and demand in bonds. The Federal Reserve has a whopping balance sheet of $2.4 trillion in U.S. Treasury securities as of mid-April, thanks to the Fed’s bond-buying stimulus program. The Treasury will eventually have to bleed some of those securities back out into the open market, which should drive up supply relative to demand and keep prices low. Thanks to the inverse relationship between bond prices and yields, this should prop up yields. However, the Fed has shown no interest in selling yet — and conceivably, the Fed would have to buy bonds again to provide stimulus, since rates have only raised by ¼ of a point.

Forecasts of core inflation over the next few years are expected to stay around 2.0%, given slow economic growth and a limited rise in interest rates. Bond yields are expected to stay low as well. The Wall Street Journal reports that Guy Haselmann of the Bank of Nova Scotia expects the nominal rate to fall to 1.25% by the end of the year, which is likely to make real yields go even further into the negative. If Haselmann is right, a return of -0.58% could be a relative bargain.

In short, whether you buy, sell, or hold bonds depends on your needs and which economic projections you believe. It’s best to stick to your original portfolio plan, since you can probably find at least one economist with a prediction that supports your plan — whatever that plan happens to be.

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