WSJ: Real Interest Rates Explained

By SIMON CONSTABLE

There are interest rates. Then there are "real" interest rates.Looking at real rates can help you determine how much your purchasing power may grow, says Mihir Worah, head of the real-return portfolio management team at Pacific Investment Management Co., or Pimco.

Many of the savviest investors suggest paying closer attention to the latter. To determine the real rate, you need to start with the rate quoted for holdings in bank accounts, bonds and the like—it is known as the nominal rate—and then adjust it for inflation.

The problem for investors comes when real interest rates are negative, when the nominal interest rate won't keep up with inflation. For instance, if Treasury bonds yield 2% a year, but inflation is 3%, then the real rate is negative 1%. That is more or less where the U.S. is now. It makes standard Treasurys unattractive to all but the most cautious investors.

What alternatives do fund investors have?

One option is to buy funds that hold Treasury inflation-protected securities, or TIPS, whose returns are linked to the consumer-price index. The largest such funds areVanguard Inflation-Protected Securities and Pimco Real Return . Currently, however, TIPS with a 10-year maturity are offering a slightly negative real return.

Another option: debt securities with yields that exceed inflation. Dennis Gartman, publisher of the Suffolk, Va.-based Gartman Letter, recommends investing in countries that produce hard assets such as iron ore and other minerals. He suggests the debt of Australia and New Zealand and points to the $2 billion closed-end Aberdeen Asia-Pacific Income FAX -1.85% fund, which holds such securities.

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