Bonds finally pay more than inflation

Ten-year US Treasury Inflation-Protected Securities (TIPS) now yield more than two per cent, for the first time since the financial crisis of 2009. Risk-free money is once again earning a real return after inflation. Financial repression, which pushed savers into riskier assets just to preserve their capital, has ended.

From minus one to plus two

The swing has been violent. In 2021, with the Federal Reserve buying bonds and holding its policy rate near zero, ten-year TIPS yields fell below minus one per cent, meaning that investors paid the government for the privilege of lending to it in real terms. Pension funds, insurers and retirees were told, in effect, that safety would cost them purchasing power. Most responded as intended, moving into equities, corporate credit, property and private funds in search of any positive return.

The reversal came in stages. The Fed began raising rates in March 2022 and has taken its policy range to 5.25 to 5.5 per cent. It has also let its bond holdings shrink. This summer the Treasury raised the size of its coupon auctions, Fitch downgraded America's credit rating, and growth data kept beating expectations. At the Jackson Hole symposium last week Jerome Powell said the Fed was prepared to raise rates further if needed and would keep policy restrictive until it was confident inflation was on track to its target. Real yields climbed through two per cent in that environment.

Every asset must clear two per cent

A guaranteed real return of two per cent on government debt raises the hurdle for every other asset. The equity risk premium, squeezed to its lowest in decades, looks mean when an investor can lock in a risk-free real return backed by the full faith and credit of the US government. Private equity and venture capital valuations will have to adjust, and so will property cap rates, to justify their spread over a two per cent real baseline.

The arithmetic is straightforward. The value of any asset is its expected future cash flow discounted at a rate made up of the risk-free real yield, expected inflation and a premium for risk. When the risk-free real yield rises by three percentage points, as it has since 2021, either the risk premium must fall by the same amount or prices must drop until expected returns rise to compensate. The equity risk premium was already thin before the move, so most of the adjustment has to come through prices.

Where the pressure lands

The assets most exposed are those whose value depends on cash flows far in the future. Technology firms that are not yet profitable, early-stage companies funded by venture capital and long-dated infrastructure projects all sit in that category, because a higher discount rate shrinks distant profits more than near ones. The share-price leaders of this year's rally, driven by excitement about artificial intelligence, carry valuations that assume profits will grow quickly for many years.

Commercial property faces a double squeeze. Office buildings are losing tenants as remote work persists, and the cap rate, the ratio of rental income to price, must rise to offer a sensible margin over a real risk-free return. For a building with falling income, a higher cap rate means a much lower valuation. Private-equity funds face a version of the same problem: leveraged buyouts done when borrowing was cheap must now be refinanced at far higher cost, and fund valuations, which are marked infrequently, have been slower to adjust than listed prices.

The winners

Savers are the obvious beneficiaries. For the first time in more than a decade, a retiree can buy a bond that protects against inflation and still earns a positive real return, without taking equity risk. Defined-benefit pension funds whose liabilities are discounted at higher rates find their funding positions improved, which makes it easier for them to buy bonds that match their obligations and hand risk to insurers. Life insurers selling annuities can offer better terms.

Governments are on the other side of the ledger. Positive real yields mean that inflation no longer shrinks the real value of debt year after year, as it did during the period of financial repression that Carmen Reinhart and others described in the decades after the Second World War. Interest costs will rise in real terms as old debt is refinanced.

The case against

The strongest counterargument comes from history. Real yields near or above today's levels were normal before 2008. In the late 1990s, when TIPS were newly issued and paid well over three per cent, American shares reached some of their highest valuations ever. High real yields did not stop a bubble then. Equities are also claims on real assets and earnings that rise with inflation, so a positive real bond yield is less of a competitor than it first appears.

That history cuts both ways. The late-1990s valuations ended in a bear market that took the S&P 500 down by roughly half between 2000 and 2002, and real yields above three per cent meant that investors who stayed in bonds did well while shares fell. The episode shows that high valuations can persist for a while in the face of competitive safe yields, not that they can persist indefinitely. The real yield now available does not dictate when shares fall; it tells investors how much they give up by waiting.

What would change the call

Real yields could fall back quickly if the economy weakens. A recession would push the Fed to cut rates and drive investors into bonds, lowering real yields and relieving pressure on other assets. The signals to watch are the August jobs report this week, consumer prices in mid-September and the Fed's meeting later that month, where new projections will show how long officials expect to keep rates high. The Treasury's next refunding announcement in early November will show whether supply keeps rising.

A two per cent real yield on Treasuries will drag down valuations of shares and private assets over the next few years, and the most richly priced corners will fall furthest. The first markdowns are likely to show up in private funds and commercial property over the coming year, as valuers catch up with public markets and refinancing deadlines arrive.