The bond market—Treasuries, high-grade corporate bonds, and municipal bonds—are experiencing depressed yields in the 1% to 3% range and near-record negative real rates with inflation running at 6%. Barron’s
Real interest rates can be effectively negative if the rate of inflation exceeds the nominal interest rate, according to Investopedia. Real interest rate refers to interest paid to borrowers minus the rate of inflation. There are instances, especially during periods of high inflation, where lenders are effectively paying borrowers when they, the borrowers, take out a loan. This is called a negative interest rate environment.
The real interest rate is the nominal interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to a bond investor. The real interest rate is calculated as the difference between the nominal interest rate and the inflation rate:
Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)
While the nominal interest rate is the interest rate actually paid on a loan or bond, the real interest rate is a reflection of the change in purchasing power derived from a bond or given up by the borrower. Real interest rates can be effectively negative if inflation exceeds the nominal interest rate of the bond.
There is risk for bond returns in 2022, when the Federal Reserve is widely expected to start lifting short-term interest rates to manage inflation.
And things could get worst for bonds if inflation persists. That could force the Fed to tighten more aggressively. It wouldn’t take a big rise in rates to generate negative returns on most bonds. The 30-year Treasury, now yielding just 1.9%, and most municipals yield 2% or less and junk bonds yield an average of 5%. Bonds would drop significantly in price if rates rise a percentage point.
The real interest rate adjusts the observed market interest rate for the effects of inflation.
“Cash has been trash for a long time but there are now new contenders for the investment garbage can. Intermediate to long-term bond funds are in that trash receptacle for sure.” Bill Gross, “Bond King”
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