Finance Basics, part 3

The third key point and second corollary is to understand inflation. Most outstanding bonds are termed nominal bonds, since their payments are fixed in nominal terms and not in real terms – that is, what they can buy. For example, if you buy a 6 percent five-year U.S. Treasury, the U.S. government will pay you $30 every six months for five years and then give you your $1,000 back at maturity. These payments are fixed contractual obligations of the U.S. government, regardless of what happens to inflation.

If inflation increases and then stays at 6 percent, the real return on this bond is zero: 6 percent nominal interest has been completely offset by 6 percent inflation. In this case, the investor is no better off having invested in this bond than having simply spent their money immediately: Their purchasing power was the same when they bought the bond as it was at the end of the five years. In contrast, if inflation dropped and then stayed at 0 percent, the real return would be 6 percent, and at the end of the five years, the investor’s real purchasing power has increased: They can buy more at the end of the five-year period than they could have at the beginning.

Understanding how inflation affects nominal interest rates is very important. The fact that nominal interest rates on long-term U.S. securities are now under 5 percent, compared to the +10 percent levels of ten years ago is due to the lower current inflation rates. However, in contrast to ten years ago, we now have what are called real return bonds (in Canada) or inflation-indexed treasury securities (in the United States). With these bonds, the interest rates are fixed in real terms, and the principal of the bond increases with inflation. In this way, investors are protected from inflation, as every year they earn their fixed rate on a principal amount that increases with inflation.

These inflation-indexed bonds are new securities in the United States, but have existed in Canada, the United Kingdom, and other countries for many years. They are extremely useful for two reasons: First, they remove one of the major concerns of retirees, which is that inflation will reduce the real value of their wealth and render their golden years ones of poverty. More important for our purposes is that they reveal more information about market expectations. The difference between the interest rate on the nominal and real return bonds is another break-even rate, in this case a break-even inflation rate.

For example, suppose that long-term U.S. government securities offered a 5 percent yield and the real return bond for the same maturity is 2.5 percent. The difference between them, 2.5 percent, is one proxy for the market’s inflation forecast. If you felt inflation was going to average only 1 percent over the long term, then it would make sense to buy the 5 percent nominal bond. In that case the real return of 4 percent (5 percent nominal rate minus 1 percent inflation) beats the 2.5 percent real return bond. On the other hand, if you felt inflation was going to average, say, 4 percent, then the inflation indexed bond makes sense, since the real return on the nominal bond is then only 1 percent (5 percent minus 4 percent inflation). In either case you should compare your own inflation forecast with that of the market; that is, listen to the market.