Nominal vs. Real Treasury Yields: A Primer

Real (inflation-adjusted) yields have surged in recent weeks, raising the question of whether it’s timely to buy inflation-indexed Treasuries (a.k.a. TIPS)? Maybe, but before you dive in keep in mind that real Treasury yields a particular mix of opportunity and risk that contrasts with standard Treasuries. Accordingly, it’s crucial to pick the right tool based on what you’re looking to achieve (or avoid) at the right time.

Superficially, nominal and real Treasury yields appear to be more or less identical except that nominal trades consistently at a premium over real, as shown by the 10-year maturities over the past two decades (see chart below). On that basis, a naïve view would always choose nominal Treasuries because the payout is higher. But that’s the wrong way to compare these two yields.

A standard Treasury security is a specific type of investment with respect to nominal and real yields. When you buy standard Treasury note you’re locking in the nominal yield, which means that the real yield will fluctuate. For example, if you bought a 10-year note yesterday (Sep. 28) you locked in a nominal yield of 3.72%, based on data. That’s the payout rate you’ll receive if you hold the note to maturity. The note’s real yield, by contrast, will fluctuate, depending on how inflation evolves over the holding period.

An inflation-adjusted Treasury note offers the opposite mix. The real yield for a 10-year TIPS was 1.39% yesterday. If you bought the security at that point you’re locking in a 1.39% real yield through maturity. The nominal yield for this TIPS investment, on the other hand, will fluctuate over the holding period.

In other words, nominal and inflation-indexed Treasuries offer complimentary tools to hedge interest-rate risks. Deciding which risk to hedge and when, andn for how long, depends on many factors, including expectations for market trends, the economy, central bank policy and other macro issues, along with an investor’s risk tolerance, objectives, holding period, etc.

In sum, Treasuries offer powerful tools for managing key risks that affect investment strategy. There are no easy answers for making optimal choices in real time, but in theory the potential is there.

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