Hedging Against Negative Real Returns

If you’re betting on bonds to preserve and protect your capital, it’s important to understand the opportunities and the risks.

A primary goal in investing is to protect the buying power of your capital. The real rate of return measures how well you are doing by taking inflation and other factors into account.  If, for example, your investments earned a nominal rate of return (unadjusted for inflation) of 9% but the rate of inflation that year was 3%, your real rate of return was 6%, with the effect that your purchasing power increased by 6%.

Bonds and other fixed income assets in your portfolio play a key role in preserving your capital, in addition to providing liquidity or income, diversifying your investments and hedging against volatility in the stock market or slowdowns in the economy. However, bonds are not risk-free:

1.       Interest rates and bond prices have an inverse relationship: if interest rates go up, bond prices go down, and vice versa. Say you bought a bond with a face value of $1,000 which pays a 5% coupon. If interest rates rose and new bonds were issued with a 6% coupon, you would have to sell your bond at a lower price to match the yield offered by the new bonds. In the opposite scenario, if interest rates fell and new bonds were issued at 4%, you could sell your bond at a premium.

2.       In addition, real rates of return can be negative when inflation is high or there is a crisis in a market sector (e.g. depressed prices because of a glut of oil) or general economic turmoil. Since the financial crisis of 2007–2009, the US Federal Reserve has kept interest rates close to zero in an effort to stimulate the economy: in fact, from 2009–2015 the annual real return on one-month US Treasury bills was negative (did not keep up with inflation). The chart below shows that this is not unusual across time and geography: for example, in the US and Canada during the period 1900–2015, government bills have delivered negative real returns approximately one-third of the time.

As is often the case in investing, diversification offsets the risk of low or even negative returns. Allocating a portion of your fixed income assets to international bonds allows you to diversify across economies with different growth, interest and inflation rates, regulatory environments, and currencies. The chart below shows nominal and real returns for one-month US Treasury Bills compared to Barclays Global Aggregate Bond Index (as of June 2016). You can see how a carefully diversified bond allocation could go beyond protecting your capital to contributing to growth in your portfolio. In effect, by incorporating geographical diversity with all the varying factors that involves, you are targeting a higher expected return while mitigating risk.