The Yield Curve and Break-Even Inflation

Understanding the relationship between bond risk and time to
maturity and duration of a bond provides the basis for understanding the bond
yield curve. The yield curve shows the yields to maturity for a series of
bonds—typically US Treasury bonds—with the same credit quality but different
maturity dates, along with the term structure for interest rates.

Exhibit 1.1 provides an example of the yield curve for
Treasury Bonds and for TIPS on May 1, 2019.

Exhibit 1.1: US Government Yield Curve for Constant Maturity Bonds and TIPS, May 1, 2019

Source: US Department of the Treasury.

Bonds with more distant maturity dates typically offer
higher interest rates than bonds with earlier maturity dates. This is not always
the case, but in the exhibit, we do see this effect, even though it is more
muted than usual. For treasuries, a thirty-year treasury was yielding 2.92
percent while a five-year treasury was yielding 2.31 percent, for instance.
Likewise, with TIPS the real yield for a thirty-year maturity was 0.95 percent,
compared with 0.48 percent for a TIPS with a five-year maturity.

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Longer-term bonds experience bigger price fluctuations as
interest rates change. When interest rates increase, the price of existing
bonds on the secondary market falls in order to calibrate the yield investors
will receive from owning existing bonds with the yields being offered by newly
issued bonds at the higher interest rates. Bonds that mature sooner are less
exposed to this price risk. Thus, shorter-term US Treasury securities are
generally considered to be among the lowest-risk investment assets when
annualized volatility represents the measure of risk, which means they tend to
be offered at a lower yield. Higher yields accompany longer-term bonds, as
investors need an added incentive to accept the higher price risks.

The shape of the yield curve is molded by two theories.
First, expectations theory suggests that the shape of the yield curve should be
reflected by beliefs about future short-term interest rates. For example,
investing in bonds over ten years can be done in two ways:

  1. Buy
    a ten-year bond, or
  2. Buy
    a one-year bond and then reinvest in a new one-year bond after one year,
    continuing with a succession of ten one-year bonds.

For markets to be in balance, these two strategies should
offer the same expected return to an investor, meaning that the combined impact
of one-year rates over ten years should match the rate for a ten-year bond. An
inverted yield curve where short-term rates exceed long-term rates can be
understood as a clear expectation that short-term interest rates will fall in
the future. Since interest rate fluctuations are extremely difficult to
predict, the expectations theory alone would probably leave the average yield
curve relatively flat.

The other theory to determine yield curve shape is the
liquidity preference theory,which
suggests a need for a risk premium to be offered for longer-term bonds to
account for their increased interest rate risk and price volatility, as
discussed. Longer-term bonds are less liquid, as well, since this price risk
could force them to be sold at a loss if an unexpected expense arose. With this
risk premium added to the expectations theory, the typical or neutral shape for
the yield curve becomes upward sloping.

With TIPS, we now have a better idea of market expectations
for future inflation, though I would not call it perfect. TIPS offer a
break-even inflation rate, defined as the difference in yields on the same
maturity of traditional treasuries and TIPS. TIPS yields may not reflect the
true underlying real interest rate because they have a few other components
built into their pricing, such as a premium for their relative illiquidity as
they represent a smaller market than treasuries, and a potential additional
premium for the protection they provide against unexpected high inflation.

Despite the other factors of TIPS pricing, the difference
between Treasury and TIPS rates for the same maturity represents a reasonable
market estimate of future inflation expectations. Exhibit 1.2 uses the same
data as in Exhibit 1.1 to find this difference.

Exhibit 1.2: US Government Yield Curve and Implied Break-Even Inflation, May 1, 2019

Source: US Department of the Treasury.

Again, we see with the thirty-year maturity that treasuries
yield a nominal 2.92 percent. Its real yield is unknown and depends on realized
future inflation. Meanwhile, a thirty-year TIPS offers a real yield of 0.95
percent. Its nominal yield is unknown, as it also depends on realized future
inflation. The difference between these yields is the implied break-even
inflation rate: 1.97 percent, or approximately 2 percent. Without a liquidity
or inflation-protection premium, this represents the market’s equilibrium
estimate of future inflation. Over the next thirty years, the markets have
priced in expectations for inflation of about 2 percent.

If realized annual inflation exceeds 2 percent over the next
thirty years, then TIPS will outperform treasuries. But if inflation falls
short, TIPS will underperform. If enough traders thought inflation would be
higher than this, they would buy TIPS
and sell treasuries, raising the
price of TIPS today, and giving us lower TIPS yields, higher treasury yields,
and a larger break-even inflation rate. Such trading would continue until the
market reaches the equilibrium we observe.

Traditional bonds are priced around the objective of getting
a return that exceeds expected inflation. If inflation is unexpectedly high,
then the real return on nominal bonds is less. TIPS, on the other hand, keep
pace with higher inflation because it triggers a higher nominal return above their
underlying real interest rate. Essentially, TIPS provide protection from
unexpected inflation. They outperform treasuries when inflation exceeds the
implied break-even inflation rate.

This is a valuable attribute when spending is expected to
grow with inflation. Traditional bonds outperform if inflation is unexpectedly
low. Low inflation also makes it easier to meet retirement spending goals, so
this outcome is less in need of protection. Retirees generally get more use
from insurance that protects from high
inflation, making TIPS a more natural candidate for retirement portfolios. In
short, TIPS provide retirees with reliable, inflation-adjusted income that will
maintain its real purchasing power.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

 


Originally posted at https://retirementresearcher.com/the-yield-curve-and-break-even-inflation/

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