By saving and investing today, most investors expect that they will be better off tomorrow. This is a reasonable premise. For this to happen, investments must, at a minimum, outpace inflation.
Stock returns have done a great job at outpacing the rate of inflation over time –generally speaking, by about 6 percentage points per year.
Bond returns also have outpaced inflation over time, but by a significantly smaller margin than stock returns. Treasury bond yields have exceeded inflation by about 2 percentage points, on average, going back to 1958.
Sometimes the relationship between inflation and bond yields gets thrown out of whack.
In high-inflation environments, it’s possible that bond yields might not keep pace with inflation. Today, we are in this type of abnormal environment – illustrated by the chart below, courtesy of JP Morgan Asset Management.
The blue line shows the yield history of the 10-year Treasury bond yield. The peak yield of nearly 16% was reached in 1981, which came during a period of very high inflation.
The average 10-year Treasury bond yield since 1958 has been 5.7% (blue line), and the yield at the end of January was 3.5%. This yield, referred to as the ‘Nominal yield’, is what the 10-year Treasury has paid bondholders in interest before taking inflation into account.
The grey line shows the same 10-year Treasury with its yield adjusted for inflation. The after-inflation yield is called the Real yield, and it has averaged about 2.1% over time.
However, with inflation running north of 5.6% today, and with the 10-year Treasury providing a Nominal yield of 3.5%, the Real (after-inflation) yield is negative, by about 2.1%.
This situation of bond yields failing to keep pace with inflation is unusual and unlikely to persist indefinitely.
Eventually, Nominal yields will move above the rate of inflation. But the adjustment process can be painful for bondholders.
This was apparent in 2022, when the US bond market fell by 13%. The steep decline was a function of the yield / price relationship for bonds. When interest rates move up quickly, bond prices and bond returns fall.
A significant course correction for bonds occurred last year. Even still, the bond markets and the path of inflation remain in flux today. It likely will take time to revert to a normal bond yield / inflation relationship.
Because of this uncertain environment, proceeding with caution in managing bond allocations is advised.
Emphasizing short-term bond funds, which carry less interest rate risk than longer-term bond funds, and inflation protected bond funds, are two ways to mitigate the negative effects of higher inflation on the bond portion of a portfolio.