There is a strange omission in many basic texts on bond investing. You cannot find the word “inflation” or its effect on yields listed in the index or chapter descriptions. Yet “real” yields are a real concern to long-term investors.

The concept of real yield is simple: the current or nominal yield minus the current year-to-year change in consumer prices.

It is difficult to generalize about real yields because they have varied so much during the 24-year bond bull market we have been experiencing. The observable trends are lower real bond yields since 1995 and lower
real treasury bill yields since 1990.

Statistics Canada’s latest figures show a 2% rise in the consumer price index. Thus, the real or inflation-adjusted yield on the benchmark 10-year Government of Canada bond is the bond’s 4.3% current nominal yield minus 2.%, to get 2.3%.

Real yields from the stock market have been negative for long periods since 1981. The S&P/TSX composite index’s inflation-adjusted yield was negative until 1992. Mind you, the bull market that followed 1982 provided capital gains to offset that negative return.

Since 1999, the TSX index’s real return has been mostly negative. The index’s current 1.7% yield is minus 0.3% after deducting the 2% inflation rate.

Since inflation and interest rates peaked in 1981, the real yield on longest-term Government of Canada bonds (maturities of more than 10 years) has varied between about 1% and almost 10%.

For three-month treasury bills, the real yield has been as low as a negative 1.8% and as high as 9.4%.

Recently, the real return on long-term
Canada bonds has been about 2.7% and the real return on three-month T-bills about 0.4%.

Here are the highs and lows of real yields on longest-term government bonds and shortest-term treasury bills since 1981:

> Long bond real yields made lows in 1981 at 0.9% (nominal yield 13.5%) and in 2003 also at 0.9% (nominal yield 5.4%).

> Long-bond highs in real yield were in 1984 at 9.7% (nominal yield 13.8%) and in 1994 at 9.4% (nominal yield 9.5%).

Three-month treasury bill yields have made a series of lows, the most recent giving negative real yields.

> In 1982, the real yield dropped to 0.4% (nominal yield 9.8%). In 2001, real yield was 0.2% (nominal yield 4.3%). In 2002, real yield was 0.1% (nominal yield 2%). In late 2002, real yield was minus 1.8% (nominal 2.7%). In 2004, real yield was minus 0.4% (nominal yield 2%).

> The high point in T-bill real yields came in 1990 at 9.4% (nominal yield 13.8%).

There is no consensus view of what average or “normal” real returns for bonds or treasury bills should be. Interest rates move in long, multi-decade secular trends, which makes the question difficult if not impossible to answer.

Recently, however, investment analysts report inflation-adjusted returns on British government bonds are less than 2% — the lowest in three centuries of recorded bond yields.

Analysts at Morgan Stanley who produced the research, therefore, conclude interest rates must now rise to revert upward.

There is another way real yields could rise — not through inflation, but deflation. If consumer prices no longer rose or declined, returns on bonds would rise. This would happen even if yields continued to drop, as would be consistent with a continuing bond bull market.

The secular or supra-secular trend also answers the question: “Why are interest rates so low?” The secular trend is taking them downward, just as a secular bond bull market took rates to even deeper lows in the 1940s.

Why interest rates move in such long secular cycles is a puzzle. Economist and author Sidney Homer wouldn’t, or couldn’t, venture an answer. The recent action of the bond market, ultra-sensitive to inflation, indicates there is no big inflation looming.
That may be a hint that real yields will improve without another upsurge of nominal interest rates, short and long. IE