In our final Active Insights series on inflation, we provide a framework for investors to distinguish between nominal bond yields, break-even rates (market implied inflation over time), and real yields. Investors can monitor these relationships to understand the underlying drivers of nominal yields.
Nominal yields refer to the current yield on U.S. Treasury notes and bonds. U.S. Treasury notes are issued in 2, 3, 5, 7, and 10-year maturities. Treasury bonds are issued with 20- and 30-year maturities.
Real yields refer to the current yield on Treasury Inflation-Protected Securities (TIPS). First issued in 1997 by the Treasury, these securities pay a fixed rate of interest but their principal is adjusted based on changes in CPI, therefore providing investors protection against realized inflation. TIPS are currently offered in 5, 10, and 30- year maturities.
The break-even rate is calculated by taking the difference between nominal yields and real yields of the same maturity. The most quoted break-even rate is the 10-year break-even, which is the difference between the 10-year nominal yield and the 10-year TIPS yield. It provides an approximation of investors' annual inflation expectations over the next 10 years.
Exhibit 1 shows nominal, real, and break-even rates for the 10-year going back to 2003. The current 10-year break-even rate of 2.35% is the highest it has been since April 2013. In other words, the bond market is currently anticipating a 2.35% annual inflation rate for the next decade. Rising inflation expectations are driving nominal yields higher.
Exhibit 2 shows the same data going back to the start of 2020. As concerns about the global pandemic and ensuing economic shutdowns drove sharp risk-off sentiment, the yield on 10-year U.S. notes moved from 1.88% at the start of the year to a closing low of 0.54% on March 9. Real yields moved negative as nominal yields compressed. However, as the bond market began to consider the path to reopening, investors increased their expectations for both economic growth and inflation. Since March 2020, nominal yields have rallied while real yields have remained negative, leading to a sharp increase in the 10-year break-even rate. Inflation expectations are rising.
Investors can monitor the relationship between U.S. nominal bond yields, TIPS yields, and break-even rates daily. Further, elevated inflation expectations may present a headwind to TIPS performance. Nominal bond prices can benefit from falling break-even rates or real yields, but TIPS prices only benefit from falling real yields. If investors believe inflation is likely to increase going forward, this does not necessarily mean that TIPS will outperform U.S. nominal bonds.
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Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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