No Longer A True Risk-Free Rate

by: Ben Emons

Our financial system is built upon two premises. It is a fiat currency system that is comprised of free floating currencies backed by a paper standard, the reserve currency. The dominant factor is the US dollar at which many currencies are valued against. The other feature is financial assets valued of a benchmark, a reference rate dubbed as the "risk free rate". Whether one looks at finance such as the capital asset pricing model (CAPM) or at investment grade securities, in general a "risk free rate" is an important assumption. The financial crisis of 2008 may have changed the way the global financial system operated. For one, the direct influence on asset prices by global central banks has been unprecedented. Another reason is that it has long been assumed there was a "risk-free instrument", like a Treasury bill or a government bond. They were viewed as boring instruments with a low return because they are public goods. The onset of the financial crisis saw large guarantees by governments of their financial systems, and as economies fell into a deep recession, automatic stabilizers as well as additional fiscal stimulus increased governments' total debt. What was normally considered as a steady, boring investment became a volatile instrument with credit risk characteristics.

To perhaps state it in bold terms, there is no longer a "true" risk free rate. There were several signs why. For example, Treasury bills have yielded near zero or negative in real terms over the past few years. Even though this may be a sign of "safety", conceivably no or negative return implies no risk; in general, investors reject a negative or zero yield as being investable, either per guidelines or psychologically. As rating agencies downgraded a variety of sovereign issuers, including the United States and the United Kingdom, the universe of AAA-rated government bond issuers has shrunk. The effect of this was dramatic on smaller bond markets; for example, Sweden and Australia saw an increase of foreign ownership, up to 85 percent, according to data of the Swedish and Australian Treasury. Such high ownership has served in crisis times as a potential catalyst for sudden capital withdrawal, affecting the value of bonds adversely. Thus, even though Australian and Swedish governments are AAA, it does not mean they are 'risk free'.

There was flight to quality during 2011 and 2012 stemming from the European debt crisis. This led to large inflows into corporate bonds, specifically those in the United States. The yield on the Barclays BBB-rated corporate bond index fell to a record low of 2.56 percent in 2012, below that of the yield on a 30-year U.S. Treasury bond at some point. This is a reflection of investors' perception of safety, whereby corporations are seen as having a sounder, healthier financial state than the government. That said, a corporate bond is per definition never defined as "risk free" because it is generally lower rated than a government bond, and companies are vulnerable to the economy, competition, and access to capital markets.

The European debt crisis revealed what modern-day sovereign risk is about. European government bond yields became distressed because of a combination of heightened political, economic, and financial risk. A good example was Italy which in 2005 was perceived almost as safe as Germany when Italian government bonds yielded a 15 basis points over German government bonds. During the 2010-2012 European debt crises this perception drastically changed. Due to heightened political risk Italy's sovereign rating was downgraded several times. When Italian bond spreads widened to a record of 600 basis points to Germany, investors received a "wake up call" about the true risk of Italian sovereign debt. Even when the European Central Bank took decisive action in 2012, investors today still demand a risk premium of 250 basis points to invest in Italian bonds.

These examples show how the idea of a risk free rate can drastically change. It sparked a debate among market practitioners whether the risk free rate is no longer a suitable input for risk premiums. Take the equity risk premium as another example. It is the difference between equity and bond expected returns. This premium moved closer to 5 percent in 2012, the highest since the 1960s. Historical data on equity risk premiums by Ibbotson has shown that at ultra low levels of risk-free rates, the risk premiums represent an "old normal." That created the perception stocks may be dramatically undervalued. That could not be fully correct because historical models are using a risk-free rate based on the assumption of growth rates from better times. It would overestimate the value of equities and perhaps other riskier assets such as corporate bonds. To that effect, risk premiums may appear to be too narrow. If today's risk-free rate appears to be a rate that is "normalized" to pre crisis levels, while using risk premiums and growth rates from a crisis period, the estimates of asset values may come out too low. In other words, risk premiums would be too wide. The present-day risk-free rate resembles an "upside-down" world. The rate is distorted on the one hand by flight to safety and central banks; on the other hand, the risk-free rate is assumed in models when past growth was higher.

That leaves the question if there is an "alternative" risk free rate? In a world of low returns and near zero interest rates, developed market government debt is seen as less 'safe'. Its interest rate risk is the highest in history because of record low rates. But that risk is also in other fixed income securities. To assume there would be an alternative risk free rate implies a whole set of new assumptions to determine value of financial assets. Slowly but surely, the financial system is morphing into something new, whereby functioning on a risk free rate as well as a reserve currency has come into question. For investors it means that valuations of bonds, currencies, derivatives as well as equities have to be evaluated carefully. It requires a selective, defensive and pickier type strategy to achieve positive returns. This does not mean one should no longer invest in bonds. On the contrary, bonds are by nature defensive, and in an environment knowing nothing is really "risk free", there are various of bond sectors like corporate, non-agency MBS, high yield and global bonds that can continue to provide value.

Disclaimer

This article contains the current opinions of the author but not necessarily those of PIMCO. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.