Real yields are the real deal

• Where will bond yields go from here?
• Evolution of real yields
• Where we see opportunity

Investors are trying to make peace with a mantra that most global central banks have been warning about all year: interest rates are going to be higher for longer. Once unthinkable bond yields at the beginning of 2023 have now become the new (more painful) normal and investors who chose to ignore this possibility must now adjust their mindset. The move in yields has been so extreme it’s forced bullish bond investors to capitulate and Wall Street strategists to revise their rate forecasts.

Where will bond yields go from here?

Yields on the 10-year German government bond is close to 3%, a level not seen since 2011. In the U.S., the 10-year bond yield reached 5%, a level not seen since before the Global Financial Crisis 15 years ago, before pulling back. Higher bond yields mean lower bond prices and potential losses for investors.

At the heart of the selloff has been the world’s longest-dated bonds (i.e., those maturing the farthest in the future), which are most exposed to the “higher for longer” narrative and, more recently, an inflation scare from higher oil prices. The question now becomes, how much higher can bond yields go?

Although we believe bond yields are unlikely to go significantly higher from here, this question is actually more rhetorical than anything. As with all facts of investing, we rarely deal with absolutes and are more often dealing in risk/reward nuances.

The evolution of real yields

The other interesting piece of this interest rate puzzle is the evolution of real yields. The real yield of a fixed income instrument is simply the yield of a bond (known as the nominal yield) minus inflation or the inflation-adjusted return. As an example, if a bond is yielding 4% and inflation is running at 4%, the bond’s real yield is 0%.
Since the Global Financial Crisis, many central banks around the world have used uber-loose monetary policies to keep real yields very low – and, in many instances, negative – in order to stimulate consumption and investment. The main goal here was to promote higher economic growth.

Now, however, the swift rise in nominal bond yields has also given rise to real yields which now sit firmly in positive territory across the yield curve. All things being equal, higher real yields will have the opposite impact to negative real yields. Consumers, corporations and the economy are likely to curtail spending and borrowing, which will slow economic growth.

How dramatic has the rise in real yields been? The most sensitive investment to real yields is the real return bond. It is extremely sensitive to real yields because it compensates investors for inflation, therefore isolating the real yield. Let’s illustrate.

Figure 1 shows the yield on the Government of Canada Real Return Bond with a coupon of 0.50% due in 2050. This is a five-year chart and what we see is astonishing. During the pandemic, the real yield on this bond tended to be negative, thus speaking to what we mentioned before about the Bank of Canada’s extremely accommodative monetary policy and bond purchases to stimulate the economy. The resulting low yield on the bond was -0.35% in November 2020, and today the real yield is over 2%. From a price perspective, the bond has declined from $126 to $68. As we said, it’s astonishing!

Figure 1: Government of Canada real return bond 0.50% coupon due in 2050 – yield to maturity

Source: Bloomberg

Where we see opportunity

The price collapse has been enormous, but we see value at these levels as the fundamentals begin to trump the negative sentiment. We believe real yields are unsustainably high and are poised to decline over the medium term.

The buy thesis here is two-fold. First, inflation seems to be peaking and any decline would be very positive for the bond as yields decline. Second, high real yields slow the economy. Or, in the worst-case scenario, they drive the economy into recession, causing the Bank of Canada to once again embark on expansionary monetary policy to bring down interest rates and real yields and boost bond prices. In either scenario, we see a very favorable risk/reward emerging in this real return bond.

The last couple of years have been a difficult time for fixed income investors. Yet similar to the stock market sell offs, there are some great opportunities. We’re seeing many such opportunities in the bond market, with real return bonds being one great example.

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