Rethinking Risk and Return amid Negative Real Yields | Lord Abbett
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Market View

Inflation-adjusted U.S. Treasury yields remain below zero. How might investors respond?

Read time: 4 minutes
 

Markets appear to be sending a conflicting message, with declining interest rates and inflation expectations, even as monthly inflation data reaches the highest levels of the past decade, and equity markets continue to reach new, all-time highs. Typically, declining rates and inflation expectations signal that markets anticipate a slowing economy, not something associated with rising equity valuations. While it is reasonable for investors to wonder if markets have it wrong somehow, one conclusion is inescapable: The difference between interest rates and inflation, often referred to as “real” yields, is unusually low, which has important ramifications for investors, as well as potential implications for U.S. economic growth.

While most investors and consumers do not typically consider real yields when making decisions about purchases or investments, many economists—including those at the U.S. Federal Reserve (Fed)—pay close attention. The reason is that real yields can impact investing behavior, economic decisions, and important parts of the broader economy, such as real estate valuations. For example, negative real yields tend to incentivize more borrowing; potential homeowners who are thinking about the economics of owning a home may view the borrowing cost as relatively inexpensive, especially when they are expecting the home to appreciate in value (which would be consistent with an inflationary environment). Companies making revenue and cost projections may decide that the cost of financing a project via debt to be paid in the future seems inexpensive relative to potentially inflated returns.

Of course, negative real yields hurt investors who have money today. A conservative investor who keeps their money in cash or “risk-free” U.S. Treasuries will find that the purchasing power of that money has lessened over time. As such, negative real yields tend to incentivize investors to make investment decisions that will generate higher returns, despite the higher risks that accompany those returns. In general, low real yields will tend to stimulate economic activity and make capital inexpensive for those who wish to spend or to grow a business, while higher real yields will make it more expensive to borrow and more appealing for investors to keep money in less risky investments. Thus, the Fed watches real yields closely in determining how stimulative its monetary policy is.

Negative Real Rates Are Rare

Of course, there have been very few periods historically when real yields have been negative; before the 2008 financial crisis, they tended to range between 1% and 5%. Negative real yields are far from the norm, and it took extraordinary circumstances to achieve them the last time around. There is also some question around how best to calculate real yields; if we are only looking at current inflation, does it really make sense to compare that to long-term yields if inflation is expected to drop in the future? Monthly inflation is a bit of a noisy data series, after all. Fortunately, we have had the ability to consider the market’s expectations for future inflation for the past 20 years, with the development of the TIPS and CPI swap markets.

 

Figure 1. Interest Rates Historically Have Been Higher than Inflation
Data for the period January 31, 1962–July 31, 2021

Source: Bloomberg Index Services Limited and Bureau of Labor Statistics. Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services. The USD inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In a zero-coupon inflation swap, only one payment is done at maturity, where one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index. Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.

 

However we choose to calculate real yields—the more volatile series using recent inflation prints, or the shorter data series that considers market expectations—we can see that they are directionally similar, and that the recent plunge to negative levels is an historic anomaly. Markets have demanded compensation above the rate of inflation until the post-GFC era of quantitative easing (QE) and other central bank involvement.

While the Fed’s heavy levels of QE may not have been the only reason that real yields stayed negative from 2011 to 2013, there can be no question that the combination of the central bank’s Zero Interest Rate Policy (ZIRP), market expectations of accommodative policy, and the Fed’s QE-related purchases of U.S. Treasuries had quite a bit to do with market valuations. Indeed, the sharp move higher in real yields in 2013 was triggered by the announcement that the Fed would consider beginning reducing their QE program, an event commonly referred to as the “Taper Tantrum.” If nothing else, investors generally demand higher returns than inflation, even from Treasuries, when the Fed is not actively involved in behavior and messaging that may distort valuations. Some investors reasonably wonder if real yields could shoot higher again in the event that the Fed indicates plans for tapering asset purchases in the coming months. We do not believe they will move as dramatically as they did in 2013 for a variety of reasons: The economic environment is different; more thorough and timely guidance from the Fed lessens the chance for a tapering “surprise”; and aggressive monetary accommodation from other major central banks has resulted in negative real yields in other countries. However, such a consideration does highlight many of the risks for investors in today’s negative-yielding environment.

Takeaways for Investors

Where does this leave investors? Those who choose to remain in cash or cash-equivalent investments will watch the value of their cash erode rapidly as long as inflation remains elevated. Investors who reach for yield may end up with inappropriate amounts of risk, or even just with unfamiliar levels of risk that impact decision making in negative ways.

While there are no easy answers, we think investors should reassess their return expectations and reconsider prior notions of risk and return. For example, many bond investors will view risk in terms of credit ratings, and yet, BBB-rated bonds maturing within one year historically have displayed less volatility and even lower default likelihood than A-rated bonds maturing in 10 years; shorter-dated ‘BBB’ bonds have also shown far less performance volatility than even a 10-year U.S. Treasury. Yet many investors will maintain a core part of their portfolios in Treasuries for perceived safety, while reaching for ever higher returns with other parts of their portfolios to offset the performance drag from Treasuries’ low yields. In such an environment, when the Fed is most directly distorting the valuations of U.S. Treasuries, incremental steps out of “risk-free” government bonds and into other quality assets can boost return expectations and possibly reduce performance sensitivity to future Fed actions.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary and Index Definitions

The U.S. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

CPI Swaps are derivative instruments used to hedge inflation risk (tied to the U.S. Consumer Price Index) by transferring inflation risk from one party to another through an exchange of cash flows.

“U.S. Federal Reserve” refers to the Federal Reserve System, the central bank of the United States. 

GFC refers to the global financial crisis of 2008–09.

Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.

Taper tantrum is a term popularly used to describe the 2013 increase in U.S. Treasury yields, which resulted from the U.S. Federal Reserve's use of tapering to gradually reduce the amount of monetary stimulus in the economy.

TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

The TIPS/Treasury breakeven rate (five-year inflation expectation rate) is calculated as the difference between the five-year U.S. Treasury rate and the five-year U.S. Treasury inflation-indexed security rate. 

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.

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