Market Beat: Understanding real interest rates
Investors who own bonds as a part of their portfolio should understand what the term “real interest rate” means.
The real interest rate is the coupon rate you receive on a bond minus the rate of inflation. If your rate of return is less than the rate of inflation, that means that you are losing purchasing power over time.
Currently, real interest rates on short-term bonds are negative, which means money put into short-term bonds will decline in value relative to the rising cost of the goods and services that you purchase.
According to government statistics, inflation has averaged about 2.4 percent over the last 10 years. That means that long-term investors need to get a return of at least that in order to just maintain their purchasing power over time.
Right now the benchmark 10-year US Treasury bond is yielding 2.6 percent, so a 10-year Treasury is only providing a real return of 0.2 percent if inflation stays about the same for the next 10 years.
The government statistics use a measure of inflation known as the CPI, or consumer price index. There are economists who claim that real inflation is actually higher than the CPI number. According to John Williams at Shadow Government Statistics, inflation is actually running closer to 5 percent.
Historically, the Fed funds rate has averaged around 5 percent, today it is at 0.25 percent and has been there for several years. In normal times, a retiree fortunate enough to have a million dollars to retire on could invest in 10-year Treasury bonds and receive an income of $45,000 to $50,000 per year risk free. Today you’d only receive about $26,000.
As long as these short-term real interest rates remain negative, there won’t be much incentive for long-term investors to purchase bonds, and most will look instead to dividend paying stocks.
If and when interest rates begin rising back to historical norms, we may see money fleeing the stock market into bonds that have positive real rates of return.
Interest rates have risen over the last year. Over a year ago, the 10-year Treasury bond hit a 200-year low, yielding less than 1.4 percent. Since then, rates have risen but are still well below historical norms.
Bonds won’t really provide much competition to stocks unless the real interest rates turn positive, or there is a “flight to quality” short-term event.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information on his money management service can be found at his blog at http://www.sellacalloption.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.