It’s been published everywhere, we’re all aware of it. Retirees and savers can’t stand it, borrowers can’t get enough of it. I’m talking about interest rates.
Today, nominal interest rates are below zero in many countries, including Germany, Denmark, Switzerland, Sweden and Japan. The common belief that zero is the lower bound for rates have been turned on it’s head. Contrary to what the financial media are publishing, negative real returns across countries have been quite common.
Why are real rates of return important?
In 1975, a loaf of bread cost 24 cents. A litre of milk cost 35 cents (more for soy), and petrol cost 57 cents a litre. Today, a loaf of bread costs $2.84, a litre of milk costs $1.45 (almost $5 for Bonsoy!), and petrol costs $1.20 a litre.
It’s simple, when the prices of goods and services increase, consumers can buy fewer of them with every dollar they’ve saved. This is called inflation, and it eats into investors’ returns.
When financial boffins talk about real return, they’re talking about returns adjusted for inflation. This is super important, because inflation affects our cost of living, investors must consider the inflation-adjusted, or real return of their investments. When inflation outpaces the nominal returns on an investment, investors experience negative real returns and actually lose purchasing power.
A brief history lesson
Exhibit 1 shows the annual real returns on one-month US Treasury bills. From 2009 to 2015, the annual real return was negative. This circumstance is not unprecedented. Since 1900, the US has had negative real returns in over a third of those years. And negative real returns on government bills are not exclusive to the US. All countries listed in Exhibit 2 have had negative real returns on their respective government bills in at least one out of every five years from 1900 to 2015.
If you think Australia is immune to this theory, think again folks. Australia experienced negative real returns 36% of the time!
Please sir, I want some more
I get it, rolling over short-term deposits/bills doesn’t seem appealing, and rightly so. Exhibit 3 shows that the return of one-month US Treasury bills has not kept pace with inflation over the past 10 years. But even when the real return on bills is negative, a relatively common occurrence, bond investors may still achieve positive and much higher expected real returns by broadening their investment universe.
The bond market is composed of thousands of global bonds with different characteristics. Many of those bonds allow investors to target global term and credit premiums, which in turn may provide positive real returns even in low interest rate environments. Exhibit 3 also shows that the Barclays Global Aggregate Bond Index has outpaced inflation while maintaining low real return volatility of 3.4% annualised over the past 10 years.
Global diversification is often thought of as a tool for reducing risk. However, when it comes to fixed income, global portfolios can also play an important role in the pursuit of increased expected returns. Even if the expected real returns of bonds in one country are negative, another yield curve may provide positive expected real returns. The flexibility to pursue higher expected returns by investing in bonds around the world can be an important defence against low, and even negative, yields.
The end game
The goal of many investors is to grow some (or all) of their savings in real terms. Even in a low interest rate environment, there may be bond investments that can still achieve this goal. In particular, investors who target global term and credit premiums should be better positioned to pursue higher expected returns.