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Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

Anyone who even casually pays attention to the financial media has likely become familiar with the current state of inflation as well as how high interest rates have risen over the past ~2 years. Inflation has come down from its recent highs but remains well above the FOMC’s target and is currently 1% higher than its average over the past decade*. Similarly, fixed income yields across the curve are at or near their highest levels over the same timeframe. At the intersection of yield and inflation is what we call real yield. Real yield is essentially an inflation adjusted measure of yield. This tells you how the spending power of an invested dollar increases versus traditional yield which measures growth on a nominal basis. A positive real yield means that the yield is higher than inflation while a negative real yield means that inflation is higher than the yield.

Depending on the purpose of an investment, real yields may or may not be a high priority data point in your analysis. For most fixed income allocations where safety and return of principal are priority #1, the known aspects of owning individual bonds (known cash flow, known redemption value, and a known redemption date) are likely the most important considerations when choosing an investment. Expected return and yield (whether real or nominal) are likely a secondary consideration when allocating to fixed income (i.e. owning little or no fixed income because yields are low is likely not in alignment with most investor’s long-term financial plans).

That being said, when the fixed income landscape presents attractive yield opportunities, it gives investors the ability to receive the known aspects that individual bonds provide while also earning attractive returns. Now is one of those times. The yields that are available in high-quality fixed income are at or near their most attractive levels in over a decade from both a nominal yield perspective as well as a real yield perspective. Nominal yields are regularly talked about, so today I wanted to shine some light on how attractive real yields are right now. To highlight the real yield opportunity, the graph below compares the 5-year BBB corporate bond yield* with the market expected average inflation* over the next 5 years. The difference between these two numbers provides the expected 5-year real yield for BBB rated corporate bonds.

Click here to enlarge

The top portion of the graph shows the BBB corporate yields (white line) and the expected inflation rate (orange line). The bottom portion shows the real yield, which is the difference between the two. Two things likely jump out at you: 1) post-COVID created a unique scenario where yields were below expected inflation (red shaded regions), and 2) we are currently at some of the most attractive levels on BOTH a nominal yield basis and a real yield basis over the past decade. Based on these metrics, an investor would expect to earn ~3.55% ABOVE expected inflation by purchasing a 5-year BBB rated bond today. This is an opportunity that has not been available in a long time and may not last very long. The post-COVID negative real yield environment is a good reminder to not take positive real yields for granted, as they are not a given and can disappear quickly.

While short-term yields are certainly attractive relative to recent history, when thinking about your long-term financial plan, consider extending out into longer maturity bonds and locking in the yield opportunity that is currently presenting itself. Real yields at the levels we are currently seeing have been exceedingly rare in recent memory and may not be around much longer. Contact your financial advisor to discuss how to take advantage of the current interest rate environment.

*Inflation used was Consumer Price Index year-over-year. The 5-year BBB corporate bond yield is the Bloomberg BBB-, BBB, BBB+ 5-year BVAL yield. Market expected inflation is Bloomberg 5-year breakeven inflation rate.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.

To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.