Thus, they should avoid long -
term nominal bonds (though long - term TIPS would be perfectly appropriate).
If you hold long -
term nominal bonds, you win if deflation shows up.
Long -
term nominal bonds, like those in the long - term Treasury fund, have significant risk of returning much less in real terms than in nominal terms, due to the risk of unexpected inflation.
And expectations of higher rates of inflation are being priced more aggressively into longer -
term nominal bonds.
Segregate «special funds» (for emergencies, saving for a house down - payment, college for the kids) in ultra-safe cash or short -
term nominal bonds (CDs are good).
Not exact matches
By secular reflation, we mean at least a decade in which short - and long -
term interest rates stay habitually below
nominal GDP growth and high grade
bonds are not really
bonds any more: delivering trend returns that are close to zero or even negative.
Over the long
term the
nominal return on a duration - managed
bond portfolio (or
bond index — the duration on those doesn't change very much) converges on the starting yield.
The largest annual loss in long
bonds is ony around 15 % in
nominal terms.
In contrast, medium -
term inflation expectations implied by financial market prices, which are calculated as the difference between
nominal and indexed
bond yields, have been broadly stable at around 2.6 per cent over the past nine months.
Medium -
term inflation expectations of financial market participants, as implied by the difference between
nominal and indexed
bond yields, have risen to around 3 per cent in October, from less than 2 per cent at the beginning of the year.
The reasonable long -
term predictability of
nominal bond returns based on their starting yields.
Banking and Monetary Statistics 1914 - 1941 (1,400 +) Data on the
nominal term structure model from Kim and Wright (6 +) Historical Federal Reserve Data NBER Macrohistory Database (2,000 +) Penn World Table 7.1 (4,400 +) Penn World Table 9.0 (3,800 +) Recession Probabilities Weekly U.S. and State
Bond Prices, 1855 - 1865 Economic Policy Uncertainty Sticky Wages and Comovement (3 +) A Millennium of Macroeconomic Data for the UK (9 +)
Despite the sharp rise in inflation expectations, 10 - year breakevens (the difference between the yield on a
nominal fixed - rate
bond and the real yield on TIPS) remain depressed relative to their long -
term history.
As mentioned at the end of the previous blog, C.D. Howe is predicting long -
term nominal returns of 2.5 % for long -
term bonds, or a paltry 0.5 % after 2 % expected annual inflation.
Second, it meant (and means) that investors are finally receiving at least a
nominal rate of interest on their cash equivalents and short -
term bond holdings going forward — a welcome change for patient value investors.
Think of 1979 - 82: by the time
bond yields were nearing their peak levels,
bond managers were making money in
nominal terms with rates rising because the income from the coupons was so high, and it set up the tremendous rally in
bonds that would last for ~ 30 years or so.
Now the credit default swap market is more than four times the size of the corporate
bond market in
nominal terms.
One way to analyze the relative value of inflation - linked
bonds versus
nominal bonds is to compare the implied break - evens priced between the two against near -
term inflation expectations.
During the life of a medium -
term debt security, the issuer may adjust the
term of maturity or the
nominal yield of the
bond according to the issuer's needs or the demands of the market - a process known as shelf registration.
Cash rates are zero in
nominal terms, and negative in real
terms,
bond yields are not going up anytime soon.
In thinking about choosing between
nominal bonds and TIPS, I have always found it helpful to think about the question in
terms of Pascal's Wager.
1) Investor inflation expectations have overshot, and it is time to sell long TIPS and buy long
nominal bonds, as long -
term inflation expectations may fall in the future.
We use
nominal returns because the
bond yield is stated in
nominal terms and includes an expected market inflation rate.
Subtract this rate from the yield on
nominal bonds - currently 4.75 percent for the 10 - year note - for a measure of the inflation expected over the
term of the
bond.
While bank accounts and savings
bonds guarantee your money in
nominal terms, there are options that may better maintain money's purchasing power.
As always, one last point to remember is that one of the advantages of TIPS over
nominal bonds is that you can take maturity risk with TIPS and earn the
term premium without taking inflation risk.
Current TIPS yields are below the long -
term average real yield of both
nominal bonds and TIPS, but the steepness of the TIPS yield curve means longer - maturity TIPS are yielding higher percentages of both the historic real return on
nominal bonds of the same maturity and the historical yield on TIPS.
Similarly, passively managed
bond funds are also available that allow investors to diversify across real and
nominal bonds as well as short -
term, intermediate -
term and long -
term bonds.