Right now, investors have been loving the yields available in a host of different bond types. Even after the Fed’s two recent cuts, cash, corporate bonds, junk bonds, and even boring Treasuries are still providing top-income opportunities for investors. Yields today are still north of 4% for many bonds and traditional income products like CDs.
However, despite those high yields, investors may want to stop short of throwing confetti and rejoicing. That yield may not be all it is cracked up to be.
That’s because the real yield on bonds is still low. With inflation starting to rise and staying stubborn, along with the Federal Reserve still planning on more cuts, bond investors might actually start feeling real income losses.
The Real Yield?
Warren Buffett famously said “Price is what you pay, value is what you get.” While the Oracle was talking about paying too much for a company’s assets, the idiom could apply to bonds, their yields, and income. That’s because the yield you get isn’t necessarily the one you’re paying for.
Bonds have two yields. The first is the nominal yield. This is the easy one to understand. It’s the yield you buy when you purchase a bond. When Walmart launches a bond offering or the U.S. Treasury raises money, they offer the bonds at coupon payment. This interest forms the basis of the yield. So, a $1,000 bond paying $40 per year in coupon payments yields 4%. The nominal yield changes as the bond is traded on the secondary market, rising and falling as the bond price changes.
However, unlike a dividend payment from a stock—which can rise—the vast bulk of bonds have static payments. That’s the problem when you consider inflation. Inflation eats away at purchasing power. So that $40 might only be worth $35 this year or $30 the next. This is the so-called real yield. Essentially, the real yield is the nominal yield minus the rate of inflation. So, the 4% yield in the above example is only a real yield of 1.4% considering the recent CPI reading for October of 2.6%. 1
Lower Real Yields
Since the 1970s/1980s, interest rates in the U.S. and nominal yields have trended lower. And thanks to higher and higher inflation, real yields have also headed south.
This chart from State Street shows the trend. Looking at the 10-year U.S. Treasury bond—which is sort of the proxy for all bonds—real rate, you can see the declining trend. And you can see how COVID-19 created a negative real rate as well as the post-COVID tightening of the last two years or so. State Street’s data stops in May. However, the current real yield for the 10-year is about 1.84%.
Source: State Street
The recent uptick in real yields is the Fed’s raising of rates coupled with the decline in inflation due to the slowing economy. This highlights how Fed policy, the economy, growth, and inflation impact the real yield or what investors actually return after inflation.
The problem is, current trends are suggesting that the Fed and real yields are between a rock and a hard place.
Inflation isn’t going down. And in fact, it rose. The annual inflation rate managed to accelerate to 2.6% in October. This was up from 2.4% in September and was the first increase in inflation in over seven months. Now, one month doesn’t make for a trend, but analysts are now concerned about several of incoming President Trump’s policies igniting inflation once again.
The issue is that the Fed is sort of stuck when it comes to the economy and its ability to raise/lower rates. The economy isn’t doing bad, but it isn’t doing great. So this type of wait-and-see, OK data environment isn’t wonderful for real yields, particularly when inflation is starting to rise and has the potential to go up further. The Fed risks tipping the economy from its achieved soft landing into a hard one and recession. It can’t cut too much, too fast because we would have a spike in inflation.
Looking Elsewhere For Real Yields
So for investors buying bonds today, we have an interesting conundrum. Stubborn inflation is meeting lower rates head-on. That’s not necessarily great when buying a bond with a static coupon payment. What investors are getting post inflation or their real yield is a lot smaller and potentially could be a lot smaller as the days go on.
The answer? Getting a tip about TIPS.
Treasury Inflation-Protected Securities (TIPS) are sort of a funky bond and offer a unique way to profit against changes to inflation. TIPS come with an initial coupon but then will reset their payouts by resetting their principal values based on changes to the CPI. A $1,000 TIPS with a 1% coupon under a flat CPI would pay $10 in interest. If the CPI jumps by 2%, the TIPS will adjust its principal upward by 2% to reach $1020 and then 1% in coupon against that would be $10.20 in interest. In periods of deflation, TIPs can adjust their principal lower.
Here is where it gets interesting with regard to real rates, real rates on TIPS, and an inflation-beating yield. Since the fall, the real yield on TIPS have been rising about 50 to 60 basis points higher. This now puts them at some of the highest points in a long time and above real yields of normal, nominal bonds. With real yields close to 2.10% for TIPS, that means they should provide returns in excess of inflation by that much. Moreover, if inflation goes higher, investors will still get that return.
This makes TIPS a top draw for fighting low real yields, the Fed’s quandary of rates, and any additional inflation created by presidential policies.
Adding TIPS is pretty easy. Any good brokerage firm should allow purchases, in both taxable and IRA accounts. You can also buy them directly from the Treasury for a $100 minimum. The Treasury also sells I-Bonds, which can also be used in concert with TIPS. I-Bonds have their own quirks but have done well in protecting against sudden spikes in inflation.
However, buying individual TIPS does come with a potential headache: taxes. Investors in bonds expect to pay taxes on the interest earned from their bonds. However, investors in TIPS also pay a ‘phantom tax’ on the principal inflation adjustments in the year they occur even though they won’t receive that adjustment until the bond matures.
To that end, TIPS ETFs or funds might be a better bet. Nonetheless, they aren’t the same as buying a TIPS security individually. They are not a one-for-one switch.
TIPS ETFs
These funds were selected based on their exposure to Treasury Inflation-Protected Securities (TIPS). They are sorted by their YTD total return, which ranges from -4.3% to 1.3%. They have expenses between 0.03% and 0.20% and assets under management between $500M and $52B. They are currently yielding between 0.2% and 8.9%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| VTIP | Vanguard Short-Term Inflation-Protected Securities Index Fund | $51.8B | 1.3% | 0.2% | 0.04% | ETF | No |
| TDTT | FlexShares iBoxx 3-Year Target Duration TIPS Index Fund | $1.8B | 0.7% | 8.9% | 0.19% | ETF | No |
| TIPX | SPDR Bloomberg 1-10 Year TIPS ETF | $1.33B | 0.1% | 7.5% | 0.15% | ETF | No |
| TIP | iShares TIPS Bond ETF | $18.8B | -0.6% | 7.8% | 0.19% | ETF | No |
| SCHP | Schwab U.S. TIPS ETF | $11.3B | -0.6% | 4.8% | 0.03% | ETF | No |
| DFIP | Dimensional Inflation-Protected Securities ETF | $507M | -0.7% | 4.7% | 0.12% | ETF | Yes |
| LTPZ | PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund | $720M | -4.3% | 8.1% | 0.20% | ETF | No |
All in all, real yields have started to trend lower as inflation has suddenly returned. With the Fed trying to balance rate cuts amid a higher inflationary backdrop, investors may not get what they paid for in terms of yield. To that end, focusing on TIPS and other real yield generating bonds could be a good bet for the near and long term.
Bottom Line
Nominal yields have been riding high ever since the Fed started to cut rates. However, their yield—which includes inflation—has been sinking, particularly now that inflation is running high again and more spikes could be on the horizon. To that end, it might make sense to add a hefty dose of TIPS to a portfolio to take advantage of their higher and adjustable real yields.
1 State Street (July 2024). Real Talk on Real Rates: A Data-Driven Look at the New Rate Paradigm
