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A Client Conversation: The Reality of Real Rates of Return | Sean Barron

As a portfolio manager, the number one question I have received over the last few years has been “What can I invest in that is safe and has a good yield?” The word “safe” is one that I sometimes have a different interpretation of than does the person asking – safe in terms of maintaining the principal or safe in terms of maintaining purchasing power? I tend to always think in terms of preservation of the purchasing power of savings (keeping up with inflation) and not in terms of a flat dollar amount.

I have been intending to post a recent conversation I had with a prospective client to highlight the impact the Fed’s actions have had on bond yields. With the recent change in stance by the Fed, this conversation serves as a good introduction to understanding the recent change in bond yields.

Conversation with a prospective client on May 17, 2013 (amended slightly for clarity):

Since our conversation the other day, I have been thinking about your situation and how to respond. To summarize my understanding, you do not need the earnings from the portfolio to maintain your current quality of life, you prefer fixed date products and FDIC insurance, and your ideal world would be earning 5% and preserving capital.

To address the last part first: back in late 2007 and early 2008, it was possible to earn 5% conservatively. Fixed income product prices (or yields) are based on a number of factors: expected inflation, real interest rates (based on supply/demand, uncertainty, return to entice people to save, etc.), and an additional yield to cover the risk of default. For the 5 year period prior to May, 2008, inflation averaged 3.1%. With an additional real interest rate of around 1% and given normal yields for default risk, 5% was not out of the realm of possibility.

Currently, the situation is drastically different. Inflation was 1% for the last year and averaged 1.6% for the last 5 years; there is a savings glut, especially in the bond market (the Fed is set to buy 80% of new Treasury issuance by the end of the year, banks have needed to buy high grade bonds for Tier 1 capital, advanced economies have an aging workforce that is moving into bonds, and emerging economies have huge foreign reserves that are invested in Treasury bonds); and there are low spreads for default risk. This leads to a negative real interest rate on “safe” assets (bonds with low default risk).

Chart 1 shows the expectation that inflation will be around 2.5% over the next 10 years. This was the initial goal of the Fed purchasing bonds in response to the threat of deflation in late 2008 (the low point on the chart).

Chart 2 shows the additional yield that comes from default risk. “Safe” credits are considered investment grade (of which, CDs, Agency bonds, and Treasury bonds sit at the top of the credit list with the lowest spread). You can see that investment grade bonds are paying less than 1% over Treasury bonds (basis points are interest rates times 100). 

Finally, total yields are currently BELOW the expected inflation rate of 2.5% (chart 3). This means that investors are willing to lose purchasing power in order to keep what they see as their only “safe” investment.

In summary, there is a savings glut, and bond rates are now earning less than expected inflation. Investors have been forced into buying riskier bonds and stocks to try to keep up with inflation.

Since you do not spend all of the income or need the additional income from your portfolio, the main question is how to minimize risk. What you are currently doing is trading cash flow certainty for purchasing power risk (losing money in real terms to inflation). We believe that is a very risky approach, as money is nothing except a tool to buy assets. Therefore, all risk should be measured in relation to purchasing power….

Since the email to the prospective client on May 17th, there has been a sell-off in bonds as a result of the Fed announcing they expect to start tapering their bond purchases before the end of the year. Treasury yields on 10 year bonds have risen from 1.95% to 2.68% and TIPS yields have risen even more, from           -0.31% to 0.57%! TIPS are a very good indicator of real interest rates. These are Treasury bonds that pay inflation plus a coupon. The yield on TIPS rose more than 10 year Treasury bond yields. This is mostly a result of a decrease in expected demand since the Fed will not be such a large buyer, as well as a lower inflation risk premium (as the Fed will put less money into the economy) and a higher liquidity premium (since TIPS are less liquid than Treasury bonds.)

As can be seen in the chart below, the coupon on TIPS had always been positive, but turned negative as investors piled into “safe” assets and the Fed entered the Treasury bond market as a large buyer. As a result of the real return turning negative, we sold off almost all our TIPS positions back in February when TIPS yields were -0.57%. Investors were willing to accept a negative real return to protect against unexpected inflation.

All of this is good news for the saver, as there are now potentially “safe” assets that will earn a positive return over inflation. Borrowing will be more costly and, all things equal, the stock market should (and has) sold off slightly as the discount rate has increased. Bond prices have fallen and this will be reflected on your monthly statement. We have stayed short in maturity, so the change should not be drastic. Real interest rates are still not at the level they should be, but they probably will not get there any time soon. Hopefully this minor adjustment by the Fed will allow rates to stabilize at more normal levels and not slow down the pace of the recovery.

Sean Barron
Portfolio Manager
Delta Trust & Bank | Trust Department


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