Fixed income

Are higher bond yields providing the real deal?

04 September 2023

Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

  • A downgrade of US debt, a splurge in government bond issuance and a fresh Japanese central bank yield initiative, have underpinned a renewed surge in rates since late July and not least a neutral rate discussion 
  • After a rapid set of moves took interest rates to a post-global-financial-crisis high, the end of this rate-hiking cycle at last appears to be in sight. However, central banks look like keeping rates higher, and for longer, than many investors expect, in their attempts to win the battle against inflation 
  • With the pace of price rises persistently high, what are bond investors to do? Ultimately, inflation-adjusted (or real) returns are most relevant for investments aimed at protecting wealth. The good news is that real yields have surged in recent months 
  • Higher real returns in isolation are not a guarantor for higher real returns in the bond market. However, in combination with increased nominal rates, higher but likely falling inflation this has provided to be an environment of higher real returns 

Since late July, the surge in global rates has reaccelerated. This time, the gravitational pull was felt at the long end of the rate curve, as opposed to the short end, which has led to the overall repricing of rate curves during this rate-hiking cycle. 

The long end in the US has been pressured by supply-and-demand concerns. Three main factors came into play here: first, the US downgrade by rating agency Fitch from AAA to AA+. Investors have been sensitised to the fact that even one of the more, if not the most, important issuers is not protected against a rating downgrade.  

However, the main reason of the downgrade was not the lack of ability to pay the debt, but rather a warning to politicians that the debt ceiling should not be used as a playing field to push agendas which come at a cost of compromising the US’ credibility as an issuer. 

The second factor underpinning higher US yields came from the Bank of Japan’s intention to be more flexible on its approach to yields, which could potentially lead to less US bond buying. This seems more theoretical in nature at this point.  

The third factor was the prospect of higher issue sizes by the US Treasury in the coming quarters.

The pull from the long end was felt through higher absolute yields, and the part reversal of the deep inversion in the US curve (with the 2-year yield higher than the 10-year yield) from less than -100 basis points (bp) to roughly -70bp between late July and late August. Indeed, the net supply of bonds via higher government issuance should not be neglected, but it seems unlikely that these factors will drive rates over the long run. 

Inflation expectations drive yields

History shows that a country’s budget deficits and debt are weakly correlated with higher yields, especially for higher-rated issuers. The main focus for investors is likely to remain the inflation outlook, and the response of the respective central banks to it, traditionally the main driver for yield trends. Eyes are likely to be more focused in this direction than usual, with the bond market seemingly transitioning into the late stage of the rate-hiking cycle. 

Certainly, the possibility remains that central banks this time hold rates higher for longer, mainly because of persistent higher core inflation (which excludes volatile energy and food price components from the index). Still, there remains the danger of central bankers being complacent in their fight against the pace of price rises. That said, higher rates are therefore unlikely to remain forever. 

Bond markets in the late stage of a cycle of cash, bonds and investment-grade corporate bonds during a hiking cycle, were explored in more detail in the article When the race is on during cycles.  

The article shows that corporate bonds (based on index performance of a respective US investment grade index with roughly a six-year duration) outperformed cash once rates peaked. During the last nine hiking cycles, this outperformance averaged 12% in the following two-year period. In other words, investors keeping funds in higher cash rates initially, would soon be re-investing into significantly lower rates. Meanwhile, returns on bond portfolios were lifted by lower market rates. 

Through the lens of real yields 

At times of unusually elevated inflation, bond investors rightly ask whether higher nominal yields are the real deal or not. Ultimately, inflation-adjusted returns are most relevant for investments aimed at protecting wealth. 

In this context, do higher nominal yields lead to higher real returns? The most obvious measure in this context seems to be the real yield, the nominal yield adjusted for inflation. The good news is that real yields have surged in recent months, along with nominal yields. In the US they are the highest they’ve been since 2008 (see chart).  

Real interest rates on the rise

Real policy rates in the US, eurozone and UK have risen for over a year. Indeed, the real rate for the first-named is back to pre-global financial crisis levels 

Real interest rates on the rise

Source: Bloomberg, Barclays Private Bank, August 2023

Finding the neutral real rate

Are real yields attractive and can an adequate level of real yields be defined? One option might be to use the equilibrium real yield, as used by central banks. This is the real yield at which an economy grows at potential, while at full employment and without pushing inflation substantially higher or lower. In other words, a yield that is just the right temperature and one that central bankers ultimately aspire to.  

This theoretical neutral real rate level changes, being dependent on the economic environment. Factors like population growth, global bond flows and productivity growth influence the rate. 

In reality, the neutral real yield (named “r-star” by central bankers) has trended substantially lower over recent decades. The US Federal Reserve (Fed) currently expects this long-time rate to trend towards 0.5%, in its own projections. That said, even within the Fed, the adequate level is debated: a recent Federal Reserve Bank of New York (New York Fed) paper puts the neutral real yield at between 0.75% to even 1.8%, depending on the model used, such as the Laubach-Williams model1

Judging how much value real yields offer

For bond investors, however, the real policy rate as illustrated above may not be applicable for two reasons. First, the short-term central bank rate may not reflect the term of a bond investment. Second, and most importantly, it is the anticipated inflation that matters most for future real returns. Given the high level of uncertainty over prospective inflation, it is clear that a guaranteed real yield can hardly be achieved when investing in nominal bonds. 

In order to assess whether a real yield provides reasonable returns, after inflation, a perfect and adverse scenario might help. A perfect scenario could be thought of as one where investors lock in a high real rate over a 12-month period, with inflation falling substantially during the holding period. By contrast, an adverse scenario could be one that is characterised by a low, or even negative, real rate, with inflation rising over the subsequent holding period. 

In this context, rather than the actual real yield, it is the outlook for inflation that matters. After rates peak, it is common for inflation to subside. After all, it is the job of central banks to hike until inflation is clearly in retreat, without overdoing it and driving the economy into a recession. 

Are central bankers winning the battle against inflation?

After substantial hikes by leading central banks, US, eurozone and the UK inflation is in retreat. In the US, after a 5.25-point surge in hikes since February 20222, the late phase of the hiking cycle appears to be here (see chart).  

Radical shift in US rates and core inflation

US policy is in a state of flux. The policy rate, known as the fed funds rate, is back to pre-global financial crisis levels, while the country’s core inflation rate has just hit levels last seen in the 1980s 

Radical shift in US rates and core inflation

Source: Bloomberg, Barclays Private Bank, August 2023

Meanwhile, core inflation has already moderated by two points in the last 10 months, from its peak at 6.7%. The Fed, along with the broader market expectations, according to Bloomberg, anticipates that core inflation will moderate towards 2.2% by 2025. 

The main uncertainty, at this point, revolves around the timing and magnitude of anticipated softening in inflation. Despite the timing uncertainty, today could potentially represent an optimal foundation for attractive real bond returns.

What does it mean for returns?

The period after the US inflation peak seen in the early 1980s shows that real rates are often a result of anchoring people’s expectations over price rises. Investors usually want higher yields to compensate for future inflation. The nominal yield demanded tends to be a result of the most recent inflation levels. In the 1980s, investors enjoyed high yields, given the expectation that inflation could remain elevated for longer. Consequently, the subsequent retreat of inflation provided relatively attractive real returns.  

Since the early 1990s, actual, rather than proxy, real rates can be obtained from inflation-linked bonds. In the US, 5-year real yields trade at around 2.2%, much higher than the 0.5% rate projected by the Fed or in a recent study by the New York Fed, which calculates 5-year term neutral rates at around 1% or lower. 

Real rates in isolation do not necessarily provide much of a guide as to future real returns for nominal bonds (real yields can only by locked in via inflation-linked bonds). Eras of relatively high nominal yields and elevated inflation, however, provide a good foundation for reasonable real returns. 


Market Perspectives September 2023

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