Real vs. Nominal US Treasury Yields: A Primer

U.S. government bonds come in two basic variations. One is the standard Treasury security: a 10-year note, for instance, pays a nominal yield – a yield that’s unprotected from the ravages of inflation. The government also issues inflation-hedged securities, formally known as Treasury Inflation-Protected Securities, commonly referred to as TIPS. 

Each bond type has a unique set of strengths and weaknesses, which vary through time, depending on current yields, economic conditions, market trends, and other factors. 

Here's a quick overview for thinking about these two types of yields from an investment perspective. Let’s start with a conventional Treasury security. When purchasing a standard government bond and assuming it’s held until it matures, the investment locks in a nominal yield. For example, buying a newly minted 10-year Treasury note that yields 4.1%, and holding it through maturity, ensures a 4.1% return over its 10-year lifecycle. (The exact return may vary slightly due to decisions on reinvestment of payouts and other factors.)

The caveat is that the 4.1% nominal yield may or may not exceed the future inflation rate over the 10-year holding period. By contrast, the real (inflation-adjusted) yield will vary for a nominal bond, perhaps significantly, for better or worse. Meantime, the nominal yield for a nominal Treasury will remain constant for a buy-and-hold investor.

The mirror opposite profile is available in TIPS. Buying and holding an inflation-hedged 10-year government bond locks in the real yield while the nominal yield varies. 

Nominal Treasuries and TIPS come in a variety of maturities and so the standard bond-investing decisions apply in both cases for deciding how far to go out on the yield curve, i.e., how much risk to take. 

The basic issue for deciding whether to buy a conventional Treasury vs. TIPS boils down to a simple question: Do you want to lock in a real yield or nominal yield? 

Another way to think about the choice of bond type: Are you more comfortable allowing the real yield to vary over the expected holding period or would you prefer a bond with a changing nominal yield?

Keep in mind that while standard Treasuries and TIPS offer guaranteed yields for buy-and-hold investing strategies, there are still risks to consider when comparing the two bond types. Perhaps the main risk is that it’s unclear if a nominal government bond will outperform TIPS, or vice versa, in the years ahead. The factors that will determine performance include the uncertain future for inflation, market sentiment, and economic conditions.

Finally, remember that TIPS and conventional Treasuries, like all bonds, can suffer capital losses within a given holding period prior to maturity. In other words, bond prices (which move inversely to yields) can be volatile at times. Although a return of principal and constant yield are guaranteed when buying and holding through maturity, the interim period can be a rough ride at times. Similarly, it’s uncertain what an investor will earn in nominal terms with TIPS, or what the real return will be for nominal government bonds. 

For assistance in deciding if TIPS are suitable for your investment portfolio, based on your risk profile, objectives, and other key factors, contact The Milwaukee Company for a free consultation.