Is this adequate compensation for the risk of investing in U.S. government bonds? History might provide some insights. Unfortunately, TIPS have only been issued in the U.S. since the late 1990's. Even the U.K. which was the first issuer of inflation-linked bonds only has data starting in 1981.
However, we can gain insight from what the real rates of return on traditional "nominal" government bonds have been over a much longer time frame. Since 1926, intermediate-term U.S. government bonds have earned an annual real return of 2.3%. By this standard, today's negative real short-term yields are clearly a result of the Fed's massive monetary easing. We therefore expect short-term rates to rise materially when Fed policy becomes more restrictive as the economy improves.
Long-term U.S. government bonds earned a marginally higher real return of 2.4% per annum since 1926. This is nearly a percentage point higher than the 1.5% real annual yield of 20-year TIPS today. Allowing for the fact that "nominal" bonds, unlike TIPS, face future inflation uncertainties and need to offer incremental compensation for this risk, we estimate that long-term real annual yields today are about 0.5% lower than the historical average.
Although a subpar economy has and will continue to act as drag on real yields over the next few years, other forces are at work to increase long-term rates. McKinsey concluded that a forthcoming investment boom in physical assets in emerging markets combined with declining savings rates from an aging global population will gradually place upwards pressures on real interest rates. Chronic government deficits are also a factor. A substantial body of research has found that in general higher deficits and public debt lead to an increase in long-term interest rates.
In particular, real yields also need to compensate investors for the ever-growing credit risk associated with U.S. government bonds. The U.S. is incurring deficits that are the highest as a percentage of GDP since 1945 and faces structural shortfalls in funding its current health care programs and Social Security. Standard & Poor's in April placed a negative outlook on the U.S.'s AAA rating and stated there's at least a one-in-three chance that the rating could be lowered in the next two years.
We believe today's low government bond yields don't offer an adequate potential real return to properly compensate investors for the associated risks. This is particularly true for long-term bonds which are more susceptible to losses when interest rates rise. Government bonds have an important portfolio role as a hedge against deflation, but beyond that thoughtful investors should look elsewhere for real return opportunities.
June 30, 2011
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