Real Yield

A real yield is the return a bond offers after the effect of inflation is removed, expressed as an annual percentage. On an ordinary nominal bond, the real yield is not something the market quotes: the coupon and the yield are stated in dollars, and what those dollars will buy is unknown until the inflation actually arrives. On an inflation-indexed bond the position reverses. Because the principal of a TIPS adjusts with the Consumer Price Index, the yield quoted at auction and in the secondary market is already a real yield, and the dollar return is the unknown.

Real yield and real rate of return describe the same idea at different points in time and are worth keeping apart. A real rate of return is calculated afterwards, from a return that has already happened and an inflation figure that has already been published, and it can be worked out for any investment. A real yield is a rate quoted now for the future, on a security whose contract makes the inflation adjustment for you.

The exact relationship is multiplicative, not additive. Purchasing-power growth is the nominal growth divided by the price growth, so a real yield is (1 + nominal) ÷ (1 + inflation) − 1. Subtracting inflation from the nominal yield is the everyday shortcut and is close enough at ordinary rates, but the two answers separate as rates rise. At a 4.3 percent nominal yield and 2.5 percent inflation, subtraction gives 1.8 percent and the exact calculation gives about 1.76 percent. At 12 percent and 9 percent the same shortcut is off by nearly a quarter of a percentage point. That arithmetic is the same one the real rate of return uses; what is different here is that on an inflation-indexed bond the market quotes the real figure and leaves the nominal one to be discovered.

Treasury publishes the market's answer every trading day. The Daily Treasury Par Real Yield Curve Rates, which Treasury also calls Real Constant Maturity Treasury rates or R-CMTs, are read from a curve estimated with a monotone convex spline method whose inputs are "bid-side prices for the most recently auctioned TIPS securities." The published points are 5, 7, 10, 20 and 30 years. That series is the closest thing to an observable price for future purchasing power that a US investor can look up.

The gap between the nominal and real curves is inflation compensation, and it is not a forecast. Subtract the real yield at a maturity from the nominal Treasury yield at the same maturity and you get what the market calls the breakeven inflation rate: the average annual inflation over that horizon at which the two bonds would produce the same result. Federal Reserve Board staff who built and maintain the TIPS yield curve describe the measure carefully. Their working paper on the subject reports evidence that these measures "are affected by an inflation risk premium that varies considerably at high frequency", and that in the early years of the sample inflation compensation was "held down ... by a premium associated with the illiquidity of TIPS at the time". The paper's own summary of the components is expectations plus an inflation risk premium minus the TIPS liquidity premium. Treating a breakeven as a clean forecast of inflation ignores two of the three terms.

A negative real yield is a real thing, not an error. When the published real yield on a TIPS is below zero, a buyer holding to maturity is contracting to receive less purchasing power than they paid, and doing so knowingly. What they are buying is the certainty: a known real outcome, backed by the Treasury, instead of an unknown one. Cash and short-term nominal bonds can deliver a negative real result too, but only after the fact and without the buyer having agreed to it in advance.

Real yields matter to plans, not just to bond buyers. A retirement projection stated in today's dollars has to be discounted at a real rate, and the market's real yield curve is the least arbitrary place to start. It is also why an inflation-linked bond ladder is used to fund a spending stream measured in purchasing power: the instrument's promise is denominated in the same units as the liability.

Look up the nominal Treasury yield and the real Treasury yield at the same maturity, both of which Treasury publishes daily. The real yield is what a TIPS of that maturity is priced to deliver above inflation. The difference is the breakeven, and it tells you what inflation assumption you are implicitly accepting when you choose one bond over the other.

A hypothetical example with illustrative rates. Suppose a ten-year nominal Treasury yields 4.3 percent and a ten-year TIPS carries a real yield of 1.8 percent. The simple breakeven is 4.3 minus 1.8, or 2.5 percent. The exact version is (1.043 ÷ 1.018) − 1, which is about 2.46 percent. If inflation over the next ten years averages more than that, the TIPS produces the better outcome, because its principal adjustment more than covers the yield the investor gave up. If inflation averages less, the nominal bond wins. Nobody knows which in advance, which is precisely why the two yields differ.

Reading the number back the other way. If an investor believes inflation will average 3 percent over the decade, that same 4.3 percent nominal yield implies a real yield of (1.043 ÷ 1.03) − 1, or about 1.26 percent, which is below the 1.8 percent the TIPS offers with no forecast required at all.

Real yield is a measure rather than a product, so what follows is what it is good and bad at telling you.

What it gets right

• It states a bond's return in the units a financial plan is actually denominated in, which is purchasing power rather than dollars.
• On inflation-indexed bonds it is observable and quoted rather than estimated, so no assumption is required.
• Treasury publishes the whole curve daily, which makes the real cost of money at different horizons a matter of public record.
• Paired with the nominal curve, it produces a market-based inflation number that updates continuously rather than monthly.

What it cannot do

• The breakeven derived from it is not a pure inflation forecast. It contains an inflation risk premium and a liquidity premium, and both move.
• The inflation adjustment tracks a published index, so a household whose own spending differs from that index gets an approximate hedge rather than an exact one.
• A real yield on a nominal bond is not knowable in advance and can only be computed after the fact.
• Real yields can be negative, and an investor who insists on a positive real yield may simply be refusing the market's price.
• It says nothing about credit, tax treatment or the annual tax on a TIPS principal adjustment, which arrives before the cash does.