Swedroe: Embracing Negative Real Yields

As readers of my books and blog posts know, I’m a big fan of Treasury inflation-protected securities (TIPS). I recommend investors consider them for a prominent role in their bond portfolios. In recent years, I’ve received numerous inquiries from investors about the wisdom of purchasing TIPS when yields have been so low.

Specifically, I’ve been asked: “Why should I buy TIPS with a negative real yield to maturity?” Given the frequency with which I’ve addressed that question, I thought it would be worthwhile sharing my response.

Why Buy TIPS?

First, the concern about buying TIPS with negative real yields could derive from the fact that investors may believe they’re guaranteeing themselves a loss in real terms. Thus, they ask: “Why would I ever want to do that?”

We’ll begin framing our answer by pointing out that this isn’t necessarily always correct. If you buy TIPS at par and hold to maturity, and we also experience deflation (negative inflation) that is greater than the negative real yield, the investor will earn a positive real return, because TIPS mature at par if there is cumulative deflation.

The following example will illustrate this point. As I write this, the yield on five-year TIPS is about -0.1 percent. Say you were to buy that TIPS at par, and over its term, inflation was -0.2 percent. Because TIPS cannot mature below par, the investor would earn a real return of 0.1 percent (-0.1 percent minus -0.2 percent). With that understood, we’ll now discuss the thought process that may well lead you to contemplate buying TIPS with a negative real yield.

The reason you should at least consider buying TIPS with a negative real yield is that you have to consider the alternative. You need to compare the real return on TIPS with the expected real return on the alternative nominal bond of the same maturity. Only then can you decide which is the more appropriate in terms of your overall portfolio. The following example contains the analysis you should perform.

Again, as of this writing, five-year TIPS are yielding about -0.1 percent, and five-year nominal Treasury notes are yielding about 1.5 percent. Thus, the breakeven rate of inflation is just 1.6 percent (1.5 percent minus -0.1 percent). If the inflation rate is more than 1.6 percent, the TIPS will earn a higher return than the nominal bond.

Relying On Expectations

In making the choice between the two instruments, we need to consider the expected real return on the nominal bond. We must also account for the expected inflation rate. An estimate of the expected inflation rate can be found in the Philadelphia Federal Reserve’s Survey of Professional Forecasters. Each quarter, this survey provides the consensus forecast from the country’s leading economists. It’s as good an estimate of inflation as there is.

The first-quarter 2015, five-year consensus forecast of inflation is 2.0 percent, which is more than the breakeven inflation rate of just 1.6 percent. That produces an expected real return on the nominal five-year note of -0.5 percent (1.5 percent minus 2.0 percent). That’s 0.4 percentage points worse than the real yield of -0.1 percent on the TIPS we considered.

Thus, if your alternative to the five-year TIPS is a five-year Treasury nominal bond, the TIPS is clearly the superior choice. You’re buying protection (insurance) against the risk of unexpected inflation, and the market is in effect paying you while providing you with that insurance. It’s not often you have an insurer charge a negative premium. Now let’s consider another alternative.

Even for individual investors who don’t want to take any credit risk, FDIC-insured CDs can provide a higher-yielding alternative than Treasurys. As of this writing, five-year CDs were available for about 2.3 percent.

Performing the same math as in our previous example, CDs produce an expected real return now of 0.3 percent (2.3 percent minus -2.0 percent). That’s 0.4 percentage points higher than the expected real return on TIPS. Note here the breakeven inflation rate is 2.4 percent (2.3 percent minus -0.1 percent).

The Insurance Decision

If you purchase TIPS in this scenario, you are paying the market 0.4 percent a year for insurance against unexpected inflation. That, of course, begs a new question: Should you consider paying that premium?

There’s no one right answer to that question. The answer depends on two things. The first is how risk-averse you are to unexpected inflation. The second is how well the rest of your portfolio of assets (including your human capital) is prepared for unexpected inflation.

Here’s the way I suggest you think about this issue: If the insurance premium is about 0.25 percent or less, I would choose the TIPS over the equivalent nominal bond. At that price, insurance is cheap. A 2004 study, “Asset Allocation with Inflation-Protected Bonds,” concluded that even with an inflation risk premium of 50 basis points, the optimal allocation to TIPS versus nominal bonds is still 60 percent.

However, not all investors have the same risk aversion to unexpected inflation. Those who have a high risk aversion to unexpected inflation should be prepared to pay a somewhat higher insurance premium.

Other Factors

There are a few other considerations to take into account when deciding between nominal and real return bonds. The first is that the research shows the standard deviation of a portfolio using inflation-indexed bonds is less than the standard deviation of a portfolio using conventional bonds.

This is especially true for more conservative portfolios. Thus, an investor who includes inflation-protected bonds can hold a higher allocation to equities—without increasing overall portfolio volatility—than an investor who only holds nominal bonds. The result is a higher expected return from the overall portfolio.

The second factor is that investors who include an allocation to commodities in their portfolio can accept more inflation risk because commodities tend to perform well when inflation is rising.

A third factor to consider is that investors who have fixed-rate liabilities (such as a fixed-rate mortgage) can accept more inflation risk because that fixed-rate liability serves as a hedge against the risk of unexpected inflation.

Another factor is that investors in the workforce who earn wages linked closely to inflation can accept more risk of inflation than those who live on fixed incomes.

Earning The Term Premium          

There’s one more important factor that you should consider. A major benefit of TIPS over nominal bonds is that owning TIPS allows investors to earn the term premium (assuming the yield curve is positively sloped) by extending the maturity of the bond without taking the risk of unexpected inflation.

For example, while the current yield on five-year TIPS is -0.1 percent, the yield on 20-year TIPS is about 0.6 percent, or 0.7 percentage points higher. Thus, you can earn the term premium without taking any inflation risk.

And while the yield on 20-year nominal bonds is 2.4 percent, or 0.9 percentage points higher than on the five-year nominal bond, you would be accepting the risks of unexpected inflation over the 20-year period in order to earn that extra 0.9 percent.

In summary, when making the decision to purchase TIPS or nominal bonds, be sure that you look beyond yield levels. Do the math and take into account all of the factors discussed here.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.