Investors often look at returns and yields without taking the impact of inflation into account. A bond's "real return" accounts for the inflation rate and more accurately describes the gain or loss on your investment over time.
Without including the effects of inflation, the return on an asset is its percent increase in value over the original cost. The yield on an asset is slightly different, as it describes the amount of income, such as dividends, that have been returned on an asset relative to its original cost. Note that the yield calculation does not include capital gains, while the return calculation does.
How to Calculate Real Return and Real Yield
The real return is simply the return an investor receives after the rate of inflation is taken into account. The math is straightforward: if a bond returns 4% in a given year and the current rate of inflation is 2%, then the real return is 2%.
Real Return = Nominal Return - Inflation
The same calculation can be used for a bond fund or any other investment type.
Similarly, the real yield is the nominal yield of a bond minus the rate of inflation. If a bond yields 5% and inflation is running at 2%, the real yield is 3%.
Real Yield = Nominal Yield - Inflation
Looking at Real Returns and Real Yields
These calculations exist because inflation reduces the purchasing power of each dollar of savings you hold. If you keep your money in a safe, its nominal value remains the same, but the real value of each dollar is diminished by the inflation rate.
Think of it this way: Assume that this year, it takes $200 to feed your family for a week. If inflation is running at 2%, then next year that same shopping cart of food will cost $204. If the return on your investments is just 1%, then you will have only $202 at the end of the year because your purchasing power has been diminished by the difference between your 1% nominal return and the 2% inflation rate. This means that your real return is a negative 1%. In order to properly manage your investments, it’s important to pay attention to real returns.
Applying These Concepts to Investing
Real yields and real returns are important considerations in investing, but by no means are they the only ones. Sometimes, investors will accept a yield below the rate of inflation in exchange for safety. This can be especially true for older investors, whose safe investments may include Certificates of Deposit (CDs), money market funds, savings bonds, and U.S. Treasury bills.
The virtue of these investments is that the danger of default is minimal. The U.S. Treasury, for example, has never failed to pay the scheduled interest on a bond. The offsetting problem, however, is that these investments have nominal yields no higher than the inflation rate or, worse, even lower. This situation is known as a negative real yield.
Negative Real Yields
Negative Real Yields is the term used to describe when an investment's nominal yield is the same or lower than the inflation rate. As a part of its strategy to rebound a fallen economy after the serious economic recession that began in 2007, the U.S. Federal Reserve cut the federal funds rate to near zero in late 2008.
By doing so, the Fed made it less costly for businesses to borrow money for investments and expansion—a strategy called quantitative easing. One of the many benefits of this strategy is that it tends to lower real unemployment rates, which the Economic Policy Institute estimates had risen in 2009 to more than 10%.
But as a result of this same strategy, the safe investment vehicles that the financial investment community often recommends to retirees and those approaching retirement fell below the inflation rate.
This is an unusual situation; throughout history Treasuries typically have offered positive real yields. But following the Great Recession, investors continued to buy Treasuries due to their status as a “safe haven” even when the real yields on these investments were negative.
The Bottom Line
The real yield of an investment isn’t the only consideration or, sometimes, even the primary consideration. Investors also need to focus as well on other considerations, including their long-term goals, the duration of their investment horizon, and their risk tolerance.
In all cases, it’s important to be aware of the impact inflation is having on your investment returns. When evaluating an investment, be sure to consider its real return and real yield, rather than simply looking at its nominal return or nominal yield. Keeping this in mind will help you manage the purchasing power of your savings.
Frequently Asked Questions (FAQs)
What drives real yields?
To understand what moves real yields, you need to break down what moves the two components of real yield: nominal yield and inflation. A given bond's yield rises and falls with market forces; when more investors want to buy bonds, the yield goes down, and vice versa. There are three main causes of inflation: demand-pull, cost-push, and expansion of monetary supply.
What happens to real GDP growth when Treasury yields decrease?
Treasury yields typically correlate with real GDP growth and other measures of economic health. When the economy is generally doing well, and real GDP is growing, investors may prefer riskier assets, so Treasury yields need to increase to attract investors. When the economy suffers a setback, investors may prefer the relative safety of Treasury bonds, which then don't have to pay such high yields.