The real yield is the nominal yield minus the expected rate of inflation, representing the return an investor earns in purchasing-power terms. It is the purest measure of the compensation for lending money over time.
Two approaches to measuring real yields:
- TIPS yields: Treasury Inflation-Protected Securities pay a real coupon and adjust their principal for realized CPI. The TIPS yield is a direct market-priced real rate.
- Fisher equation: Real yield = Nominal yield - Expected inflation. This requires an estimate of inflation expectations, which can be derived from the breakeven inflation rate (nominal yield minus TIPS yield).
Real yields are fundamental to asset pricing:
- Negative real yields mean investors are accepting returns below expected inflation, typically during periods of aggressive central bank easing or flight-to-quality demand. This occurred throughout much of 2020-2021.
- Positive real yields mean investors earn a return above inflation, which is the historical norm and a sign of tighter financial conditions.
Changes in real yields drive asset prices across markets. Rising real yields increase the discount rate applied to all future cash flows, pressuring equity valuations (especially growth stocks), real estate, and gold. Falling real yields have the opposite effect.
The level of the real yield also affects the attractiveness of fixed income relative to other asset classes, making it a key input to asset allocation decisions.