Negative Real Return Is the Price for Safety

The price to keep our money safe finally hit our face: five-year inflation indexed bonds yield from a recent auction produced a negative number, -0.55%. It means investors in these bonds are guaranteed to earn a return at 0.55% below inflation in the next five years.

As absurd as it may sound, investors don’t have a God-given right to earn a return  above inflation. If you must keep your money safe, you will have to pay the price. The price for safety changes with time. At times it’s a low return, but still positive after inflation. Right now that price for safety is a return below inflation.

Does it mean the price for safety is "too high" today? We only know it’s higher than before but we won’t know if it’s "too high" until after the fact. Under some scenarios the price can be too high. If the economy goes well without much inflation, riskier assets will do better than the safe, inflation indexed bonds. It would seem foolish to chicken out in bonds earning a pittance. If the economy stagnates with high inflation, you will be happy with a small negative real return when other assets do even worse. Which way will it go? Beats me.

Still, nobody likes negative yields after inflation. Me either. But negative yields after inflation aren’t limited to TIPS. Other bonds don’t have much of a safety margin against inflation either. The yield on five-year nominal Treasury is only 1.3% while the market expectation for inflation in the next five years is 1.9%. Nominal Treasurys also have a negative expected after-inflation return.

There are only a handful of escape hatches, none of which are perfect.

I Bonds. If you buy Series I Savings Bonds before the end of October, you get 0.2% fixed rate before inflation adjustments. The inflation adjustments for the next 12 months will be 1.14% (1.54% for the first six months, 0.74% for the second six months).

I Bonds are better than five-year TIPS but they are still nothing to write home about. Because you are also limited to buying maximum $10,000 per person ($5,000 in paper, and $5,000 electronically), the best you can do is earning $75 more per year. You can get much more than $75 a year by applying for a new credit card or switching to a reward checking account.

If it makes you feel better, go ahead and buy your I Bonds ration before the end of October. I will, but it’s far from a cure for the problem of low returns.

CDs. FDIC or NCUA insured CDs don’t have inflation protection but they can have higher yields than nominal Treasurys. If rates go up in the future, there’s also a possibility to get out early with a small penalty. If the rates go up a lot, the penalty will be much smaller than the loss on bonds and bond funds.

However, note inflation going up and interest rates going up are two different things. One does not have to lead to another. The Fed has great influence over short-term interest rates. If they hold the rates low when inflation goes up, CDs can produce negative after-inflation returns too.

Muni Bond Funds. For a taxable account in a high tax bracket, intermediate term muni bond funds still offer higher yields than comparable term CDs when taxes are taken into consideration. Here we introduce default risk (state and municipal government budgets aren’t in the greatest shape) and interest rate risk (no capped penalty for getting out early). It’s difficult to quantify these risks over CDs.

Sorry for the bad news. There’s no easy solution to the poor return on safe assets. Come think about it, there can’t be. Otherwise the yields wouldn’t be so low in the first place. I Bonds, CDs, and muni bond funds have some hope of beating low rate TIPS and Treasurys because they are geared more toward individual investors. In these limited cases, being an individual investor buying small quantities can be more advantageous than being a pension fund or foreign government wanting to buy millions or billions of dollars worth.