You will be able to read real yields and breakeven inflation and explain why real rates matter for valuations.
In 2022 Marcus's US chip designer fell much further than his world ETF, though its sales were still growing. A colleague blamed "rising real rates". Marcus nodded and didn't ask what that meant. This lesson answers the question he didn't ask, because real rates sit underneath the valuation of almost everything he owns.
A normal government bond pays a fixed amount in dollars. Its yield is a nominal yield: it says nothing about what those dollars will buy when they arrive.
An inflation-linked bond adjusts its principal for inflation, so its payments keep their purchasing power. In the US these are Treasury Inflation-Protected Securities, or TIPS, and the principal is adjusted using the US consumer price index. The yield on a TIPS bond is therefore a real yield: the return above inflation that an investor locks in by buying it and holding it to maturity.
Put the two side by side for the same maturity and you get the breakeven inflation rate: the nominal yield minus the real yield. With made-up figures, if the ten-year Treasury yields 4.2% and the ten-year TIPS yields 1.9%, ten-year breakeven inflation is 2.3%. If US inflation averages more than 2.3% a year over the next ten years, the TIPS holder comes out ahead. If it averages less, the normal Treasury holder does.
This links back to the real return formula in lesson 1.1, Nominal vs real returns and the geometric mean trap. Strictly, one plus the nominal yield equals one plus the real yield times one plus inflation, and the subtraction is the everyday approximation that markets quote.
Any asset's value is the cash it will pay you in future, discounted back to today. The discount rate starts from a risk-free rate and adds a premium for risk. When real yields rise, the base of that discount rate rises, and every future cash flow is worth less today.
The damage depends on how far away the cash is. Take one dollar of cash flow and raise the discount rate from 6% to 7%, made-up rates for the example. A dollar due in two years loses about 1.9% of its present value. A dollar due in twenty years loses about 17%.
That's the same idea as bond duration from lesson 2.5, Duration is the risk number for bonds, applied to shares. A mature company paying most of its profit out now is like a short bond. A fast-growing company whose profits are mostly expected years from now is like a long bond, and a rise in rates hits it hardest.
The effect grows when you value a company with steady growth for ever, which module 8 does in detail. With a made-up cash flow of 100 a year growing at 4%, a discount rate of 6% gives a value of 100 divided by 0.02, or 5,000. At 7%, the value is 100 divided by 0.03, about 3,333. One point on the discount rate cut the value by a third.
So when US real yields rose from below zero to well above it during 2022, the companies hit hardest were those whose value rested on distant profits. Marcus's chip designer was one. His world ETF, spread across mature and growing companies alike, fell less.
Breakeven inflation is often read as the market's inflation forecast. It's close to that, with two distortions. Investors in normal bonds want extra yield for the risk that inflation surprises upward, which pushes breakevens up. And TIPS trade less easily than normal Treasuries, especially in a crisis, which can push breakevens down. In late 2008, when investors sold anything they could to raise cash, US breakevens briefly fell to levels that implied deflation for years.
So breakevens show what the bond market is pricing, adjusted by those premia. They're useful for one thing above all: comparing with your own expectation and with what the Fed says. If breakevens are rising while the Fed says inflation is under control, the market doesn't fully believe it. They're not a forecast of what will happen, and past breakevens have often missed actual inflation by a wide margin.
The US Treasury publishes daily nominal and real yield curve rates. The St. Louis Fed's FRED database charts ten-year nominal yields, ten-year TIPS yields and ten-year breakevens, so you can see how all three have moved over decades.
For the activity, look up today's ten-year nominal and real yields from one of those sources, subtract to get breakeven inflation, and compare it with the same calculation from a year earlier.
Look up the current US 10-year nominal and real yields, calculate breakeven inflation and note how it changed over the past year.
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