Real and Nominal Rates of Return

The following excerpt is from The Bond Book, written by Annette Thau and published by McGraw-Hill.

The terms “real” rate and “nominal” rate are sometimes used to refer to rates of return on bonds. These terms represent a method of adjusting bond yields for the rate of inflation. The nominal rate measures the actual dollars earned, based on interest rate yields. To obtain the real rate, subtract the inflation rate from the nominal rate. For example, the coupon rate on the long bond is currently close to 6%. That is the nominal rate. Subtracting the current rate of inflation, which is around 2.5%, results in a real rate of return of about 3.5%.

The relationship between the real rate of return and the nominal rate has varied during the century. So has the level of interest rates. Interest rate levels are governed, first, by what is happening to prices (that is, inflation or deflation) and secondly, by expectations of what will happen to prices. Until 1950, even though interest rates were low, bonds earned a real rate of return because inflation was low. As inflation began to rise, the real rate of return began to decline, despite a rise in nominal rates. The real rate of return throughout the 1960s and 1970s was negative even though rates were high and rising. Moreover, inflation eroded the purchasing power of older issues. That was the main reason interest rates rose to such high levels: few investors were willing to purchase long-term bonds because the nominal rate did not appear high enough to compensate for anticipated increases in yield as a result of continuing high inflation.

Historically, the real rate of return on long bonds has averaged about 3% above the inflation rate. Since that is an average, it has sometimes been higher and sometimes lower. During the 1990s inflation averaged under 3% a year, and that rate is considered benign. Inflation, moreover has been relatively benign worldwide. But note that benign as it may seem, the recent low inflation rate does not mean inflation is dead. Over a 30-year period, if inflation were to remain as low as a constant 2% a year, an item costing $100 at year one would cost $181 at year 30. If inflation rates were to rise to 3% over that same 30-year period, an item costing $100 at year one would cost $243 at year 30. Beginning in 1999, the inflation rate rose slightly, and since then, concerns about inflation have increased somewhat.

Unless there is an extended period of actual deflation, nominal rates will probably continue to remain 2% to 3% above the inflation rate. But none of this is predictable. No one knows whether the next 30 years will see deflation or whether higher inflation rates will return. Some experts worry that the current economic boom will inevitably lead to inflation worldwide. Others feel that central banks will be able to keep inflation at bay. Still others point out that the recent belief that central banks can successfully control inflation, and hence manage growth, is overly optimistic. The one point no one disputes is that crystal balls have been notoriously unreliable in predicting interest rates. More to the point, no one has ever consistently predicted interest rates correctly over a period of 30 years: that is, over the life of a long-term bond.

The strategies described in this book are predicated on the assumption that interest rates cannot be predicted but that you can manage your bond portfolio so that no matter what happens, your portfolio will not suffer severe erosion.

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