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Real Interest Rates

October 1, 2021 | Commentary

  • Decades of relatively muted inflation have desensitized many investors to the important concept of real interest rates, which are the more widely followed nominal interest rates adjusted for the rate of inflation over the relevant bond’s maturity.  It is the yield you earn once purchasing power is held constant.
  • Since 1997, the U.S. Treasury has issued Treasury Inflation Protected Securities, or TIPS, alongside its traditional nominal bonds.  TIPS began their history offering small but meaningfully positive real rates of interest.  Since the Great Financial Crisis, the real yield has been drifting lower and occasionally into negative territory where it is currently.
  • Today, anyone lending to the U.S. for 10-years via TIPS is locking in a roughly -1.0% real rate (which is the nominal interest rate less CPI).  That converts to a guaranteed loss of about 10% in purchasing power over the decade.  Investors making this choice must be terribly fearful of accelerating inflation that would diminish the value of traditional bonds and stocks even more.
  • While TIPS currently fail as a long-term holding, they might be useful as a shorter-term trading vehicle.  Differences in opinion about the pace of inflation and the economy can sometimes lead to exploitable mispricings.
  • When real interest rates are so low the benefit accrues to borrowers.  As private parties identify accretive capital projects, productivity and profits should be enhanced adding to fundamental equity value.  As long as negative real rates persist, investors should acknowledge the meaningful tail wind behind equities while continuing to resist the negative real rates in TIPS. 

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