Rethinking The Risk Free Rate (Part 1): Free Lunch Currently Available Via Corporate Bonds?

by: Lawrence Weinman

A fundamental building block of financial markets has always been that within all the options, there's always a risk free asset. Risk free in this case means the investor has no risk of principal. In other words he or she would face none of the following risks:

  • Credit risk: no risk that the issuer would default on the obligations.
  • Market risk: the price of the asset would not fluctuate.

In classical finance, the asset that would meet that description has historically been the US Treasury bill. The risk of default on a short term loan to the US government was considered to be nil and the impact of changes in market interest rates on a short term bill were generally minimal.

Every other asset's pricing is based off the risk free rate. Investors need to be offered a higher than expected return in order to attract them to taking on more risk either in terms of credit risk or market risk that on a T-bill. Hence the yield differentials between Treasuries and instruments of the same maturity and currency but issued by other debtors, such as corporations. Thus the higher yield in return for taking on the greater risk of a longer maturity or price devaluation, or a combination of the two.

The always perceptive Gillian Tett of the FT has noted that at least for longer term bonds there are some market signals that the credit risk on US Treasuries is actually now greater than that of corporate bonds:

Earlier this week, I pointed out in a column that the cost of insuring the US government against default in the credit derivatives markets is now higher than for many major companies. More specifically, data from Markit shows that no less than 70 US corporate names currently command lower credit default swap spreads than the sovereign contract (currently running at 50 basis points.) A few years ago, there were none.

The credit default swap market may be pricing for a lower credit risk on some top rated corporates but that’s not necessarily the case for the ETFs based on corporate bonds vs. government bonds. The graphs below (click on each to enlarge) show the spreads between corporate bond yields and those on Treasury bonds.

The intermediate term spread of ETFs for corporate bonds vs Treasuries has actually widened of late. It is currently 2.10% for the intermediate term :

For short term maturities it is now at 1.38%:

Why has this occurred? The explanation can be traced to the following major factors:

1. A general “flight to quality” in the investment markets. CDS markets to the contrary, the US Treasury market is still the largest, most liquid market in the world. In periods of uncertainty, investors still flock to Treasury securities. Even if the credit risk on Treasuries may not be much different than that of top-grade corporates, there is still an issue of liquidity. It will always be more difficult to trade a corporate debt instrument than a Treasury. Market participants are willing to “pay” for that liquidity in terms of accepting a lower yield. This is particularly important for fund managers who can have redemptions and therefore cash needs larger than expected.

2. Structural issues. Many market participants are not equipped or don’t have a mandate to own corporate debt. If they liquidate their risky assets they need to park their cash somewhere. Treasury bills are the easiest place. Everyone has an investment policy statement that allows them to own Treasury bills and most can hold other Treasury securities as well.

3. Fed policy: The Fed has made it quite clear that it will not be raising interest rates and in fact the prospect exists that it may take additional action to push intermediate or longer rates lower.

There may not be such a thing as a free lunch, but in terms of the way folks in the credit market look at things, this differential comes pretty close. If you feel that the credit default swap market is on the right track and the credit risk on US corporates is lower than that of US Treasuries, you should be intrigued by this spread of corporates vs. Treasuries. This would be the case even if you simply feel that there is no extra credit risk in investing in investment-grade corporates over US Treasuries.

Based on this analysis, it makes sense to look carefully at these yield differentials in short as well as intermediate maturities. It’s worthwhile to consider developing a preference in the short term for corporate bond ETFs (Vanguard Short Term (NYSEARCA:BSV), iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ), SPDR Barclays Capital Short Term Bond (NYSEARCA:SCPB), Vanguard Short Term Corporate Bond Index (NASDAQ:VCSH)) vs. US Treasury ETFs with the same maturity (SPDR Barclays 1-3 Month T-Bill (NYSEARCA:BIL), iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY), iShares Barclays Short Treasury Bond (NYSEARCA:SHV)) and to examine the intermediate term Treasury EFTs (PIMCO 3-7 Year US Treasury Index (NYSEARCA:FIVZ), iShares Barclays 3-7 Year Treasury Bond (NYSEARCA:IEI)) to intermediate term coporate bond ETFs (iShares Barclays Credit Bond (CFT), iShares Barclays Intermediate Credit Bond Index (NYSEARCA:CIU), SPDR Barclays Capital Intermediate Term Corporate Bond (NYSEARCA:ITR), Vanguard Intermediate Term Corporate Bond Index (NASDAQ:VCIT)).

As an individual investor you have the luxury of not having to worry about factors #1 and 2 listed above. You should be able to have a good handle on your personal liquidity needs and you set your own investment policy as to holding some corporate debt. Therefore, you can add some of this relatively higher yield debt to your portfolio without adding much in the way of credit risk.

In the case of my client portfolios, although I am not a major market timer making big moves in and out of specific stock locations, it’s hard to review current conditions and not feel that equities have become more risky in the near term. From my view of risk and return in the current markets I would much rather try to pick up a little in yield through these bond ETFs than add equity risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. However, some clients hold positions in VCIT and VCSH.

>> Continue to Part II