In Search of Safe Havens: The Trust Deficit and Risk-free Investments!
In Search of Safe Havens: The Trust Deficit and Risk-free Investments!
In every introductory finance class, you begin with the notion of a risk-free investment, and the rate on that investment becomes the base on which you build, to get to expected returns on risky assets and investments. In fact, the standard practice that most analysts and investors follow to estimate the risk free rate is to use the government bond rate, with the only variants being whether they use a short term or a long term rate. I took this estimation process for granted until 2008, when during that crisis, I woke up to the realization that no matter what the text books say about risk-free investments, there are times when finding an investment with a guaranteed return can become an impossible task. In the aftermath of that crisis, I wrote a series of what I called my nightmare papers, starting with one titled, "What if nothing is risk free?", where I looked at the possibility that we live in a world where nothing is truly risk free. I was reminded of that paper a few weeks ago, when Fitch downgraded the US, from AAA to AA+, a relatively minor shift, but one with significant psychological consequences for investors in the largest economy in the world, whose currency still dominates global transactions. After the rating downgrade, my mailbox was inundated with questions of what this action meant for investing, in general, and for corporate finance and valuation practice, in particular, and this post is my attempt to answer them all with one post.
Risk Free Investments: Definition, Role and Measures
The place to start a discussion of risk-free rates is by answering the question of what you need for an investment to be risk-free, following up by seeing why that risk-free rate plays a central role in corporate finance and investing and then looking at the determinants of that risk-free rate.
What is a risk free investment?
For an investment to be risk-free, you have feel certain about the return you will make on it. With this definition in place, you can already see that to estimate a risk free rate, you need to be specific about your time horizon, as an investor.
For an investment to be risk free then, it has to meet two conditions. The first is that there is no risk that the issuer of the security will default on their contractual commitments. The second is that the investment generates a cash flow only at your specified duration, and with no intermediate cash flows prior to that duration, since those cash flows will then have to be reinvested at future, uncertain rates. For a five-year time horizon, then, you would need the rate on a five-year zero default-free zero coupons bond as your risk-free rate.
You can also draw a contrast between a nominal risk-free rate, where you are guaranteed a return in nominal terms, but with inflation being uncertain, the returns you are left with after inflation are no longer guaranteed, and a real risk-free rate, where you are guaranteed a return in real terms, with the investment is designed to protect you against volatile inflation. While there is an appeal to using real risk-free rates and returns, we live in a world of nominal returns, making nominal risk-free rates the dominant choice, in most investment analysis.
Why does the risk-free rate matter?
By itself, a risk-free investment may seem unexceptional, and perhaps even boring, but it is a central component of investing and corporate finance:
Determinants
So, why do risk-free rates vary across time and across currencies? If your answer is the Fed or central banks, you have lost the script, since the rates that central banks set tend to be short-term, and inaccessible, for most investors. In the US, the Fed sets the Fed Funds rate, an overnight intra-bank borrowing rate, but US treasury rates, from the 3-month to 30-year, are set at auctions, and by demand and supply. To understand the fundamentals that determine these rates, put yourself in the shoes of a buyer of these securities, and consider the following:
The recognition of these fundamentals is what gives rise to the Fisher equation for interest rates or the risk free rate:
Nominal Risk-free Rate = (1 + Expected Inflation) (1+ Real Interest Rate) -1 (or)
= Expected Inflation + Expected Real Interest Rate (as an approximation)
If you are wondering where central banks enter this equation, they can do so in three ways. The first is that central banking actions can affect expected inflation, at least in the long term, with more money-printing leading to higher inflation. The second is central banking actions can, at least at the margin, push rates above their fundamentals (expected inflation and real interest rates), by tightening monetary policy, and below their fundamentals by easing monetary policy. Since this is often achieved by raising or lowering the very short term rates set by the central bank, the central banking effect is likely to be greater at the shorter duration risk-free rates. The third is that central banks, by tightening or easing monetary policy, may affect real growth in the near term, and by doing so, affect real rates.
Having been fed the mythology that the Fed (or another central bank) set interest rates by investors and the media, you may be unconvinced, but there is no better way to show the emptiness of "the Fed did it" argument than to plot out the US treasury bond rate each year against a crude version of the fundamental risk-free rate, computed by adding the actual inflation in a year to the real GDP growth rate that year:
As you can see, the primary reasons why we saw historically low rates in the 2008-2021 time period was a combination of very low inflation and anemic real growth, and the main reason that we have seen rates rise in 2022 and 2023 is rising inflation. It is true that nominal rates follow a smoother path than the intrinsic risk free rates, but that is to be expected since the ten-year rates represent expected values for inflation and real growth over the next decade, whereas my estimates of the intrinsic rates represent one-year numbers. Thus, while inflation jumped in 2021 and 2022 to 6.98%, and investors are expecting higher inflation in the future, they are not expecting inflation to stay at those levels for the next decade.
Risk Free Rate: Measurement
Now that we have established what a risk-free rate is, why it matters and its determinants, let us look at how best to measure that risk-free rate. We will begin by looking at the standard practice of using government bond rates as riskfree rates, and why it collides with reality, move on to examine why governments default and end with an assessment of how to adjust government bond rates for that default risk.
Government Bond Rates as Risk Free
I took my first finance class a long, long time ago, and during the risk-free rate discussion, which lasted all of 90 seconds, I was told to use the US treasury rate as a risk-free rate. Not only was this an indication of how dollar-centric much of finance education used to be, but also of how much faith there was that the US treasury was default-free. Since then, as finance has globalized, that lesson has been carried, almost unchanged, into other currencies, where we are now being taught to use government bond rates in those currencies as risk-free rates. While that is convenient, it is worth emphasizing two implicit assumptions that underlie why government bond rates are viewed as risk-free:
When and Why Governments Default
Now that we have established that governments can default, let’s look at why they default. The most obvious reason is economic, where a crisis and collapse in government revenues, from taxes and other sources, causes a government to be unable meet its obligations. The likelihood of this happening should be affected by the following factors:
Source: UNCTAD |
There is a second force at play, in sovereign defaults. Ultimately, a government that chooses to default is making a political choice, as much as it is an economic one. When politics is functional, and parties across the spectrum share in the belief that default should be a last resort, with significant economic costs, there will be shared incentive in avoiding default. However, when politics becomes dysfunctional, and default is perceived as partisan, with one side of the political divide perceived as losing more from default than the other, governments may default even though they have the resources to cover their obligations.
As a lender to a government, you may not care about why a government defaults, but economic defaults generally represent more intractable problems than defaults caused by political dysfunction, which tend to be solved once the partisan pounds of flesh are extracted. In my view, the ratings downgrades of the US government fall into the latter category, since they are triggered by a uniquely US phenomenon, which is a debt limit that has to be reset each time the total debt of the US approaches that value. Since that reset has to be approved by the legislature, it becomes a mechanism for political standoffs, especially when there is a split in executive and legislative power. In fact, the first downgrade of the US occurred more than a decade ago, when S&P lowered its sovereign rating for the US from AAA to AA+ in 2011, after a debt-limit standoff at the time. The Fitch downgrade of the US, this year, was triggered by a stand-off between the administration and Congress a few months ago on the debt-limit, and one that may be revisited in a few weeks again.
Measuring Government Default Risk
With that lead-in on sovereign default risk, let us look at how sovereign default risk gets measured, again with the US as the focus. The first and most widely used measure of default risk is sovereign ratings, where ratings agencies rate countries, just as they do companies, with a rating scale that goes from AAA (Aaa) down to D(default). Fitch, Moody's and S&P all provide sovereign ratings for countries, with separate ratings for foreign currency and local currency debt. With sovereign ratings, the implicit assumption is that AAA (Aaa) rated countries have negligible or no default risk, and the ratings agencies back this up with the statistic that no AAA rated country has ever defaulted on its debt within 15 years of getting a AAA rating. That said, the number of AAA (Aaa) rated countries has dropped over time, and there are only nine countries left that have the top rating from all three ratings agencies: Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore and Australia. Canada is rated AAA by two of the ratings agencies, and after the Fitch downgrade, the US is rated Aaa only by Moody's, whereas the UK is AAA rated only by S&P.
In a reflection of the times, there have been two developments. The first is that the number of countries with the highest rating has dropped over time, as can be seen in the graph below of countries with Aaa ratings from Moody's:
If you recognize that default risk falls on a continuum, rather than in the discrete classes that ratings assign, the sovereign CDS market gives you not only more nuanced estimates of default risk, but ones that are reflect, on an updated basis, what investors think about a country's default risk. The graph below contains the sovereign CDS spreads for the US going back to 2008, and reflect the market's reactions to events (including the 2011 and 2023 debt-limit standoffs) over time:
Dealing with Government Default Risk
No matter what you think about the Fitch downgrade of US government debt, the big-picture perspective is that we are closer to the scenario where no entity is viewed as default-free than we were fifteen years ago, and it may be only a matter of time before we have to retire the notion that government bonds are default-free entirely. The questions for investors and analysts, if this occurs, becomes practical ones, including how best to estimate risk-free rates in currencies, when governments have default risk, and what the consequences are for equity risk premiums and default spreads.
1. Clean up government bond rate
Consider the two requirements that have to be met for a local-currency government bond rate to be used as a risk-free rate in that currency. The first is that the government bond has to be widely traded, making the interest rate on the bond a rate set by demand and supply in the market, rather than government edict. The second is that the government be perceived as default-free. The Swiss 10-year government bond rate, in July 2023, of 1.02% meets both criteria, making it the risk-free rate in Swiss Francs. Using a similar rationale, the German 10-year bund rate (in Euros) of 2.47% becomes the risk-free rate in Euros. With the British pound, if you stay with the Moody's ratings, things get trickier. The government bond rate of 4.42% is no longer risk-free, because it has default risk embedded in it. To clean up that default risk, we estimated a default spread of 0.64%, based upon UK's rating of Aa3, and netted this spread out from the government bond rate:
Risk-free Rate in British Pounds
= Government Bond Rate in Pounds - Default Spread for UK = 4.42% - 0.64% = 3.78%
Extending this approach to all currencies, where there is a government bond rate present, we get the riskfree rates in about 30 currencies:
Riskfree Rate in US dollars = US Treasury Bond Rate - Default spread on US T.Bond
2. Risk Premia
If you focus just on risk-free rates, you may find it counter intuitive that an increase in default risk for a country lowers the risk free rate in its currency, but looking at the big picture should explain why it is necessary. An increase in sovereign default risk is usually triggered by events that also increase risk premia in markets, pushing up government bond rates, equity risk premiums and default spreads. In fact, if you go back to my post on country risk, it becomes the key driver of the additional risk premiums that you demand in countries:
You will notice that in my July 2023 update, I used the implied equity risk premium for the US of 5.00% as my estimate of a premium for a mature market, and assumed that any country with a Aaa rating (from Moody's) would have the same premium.
Since Moody's remains the lone holdout on downgrading the US, I would use the same approach today, but assuming that Moody's downgrades the US from Aaa to Aa1, the approach will have to be modified. The implied equity risk premium for the US will still be my starting point, but countries with Aaa ratings will then be assigned equity risk premiums lower than the US, and that lower equity risk premium will become the mature market premium, to be used to get equity risk premiums for the rest of the world. Using the sovereign CDS spread of 0.30% as the basis, just for illustration, the mature market premium would drop from 5.00%, in my July 2023 update, to 4.58% (5.00% -1.42*.30%).
When safe havens become scarce...
During crises, investors seeks out safety, but that pre-supposes that there is a safe place to put your money, where you know what you will make with certainty. The Fitch downgrade of the US, by itself, is not a market-shaking event, but in conjunction with a minus 18% return on the ten-year US treasury bond in 2022, these events undercut the notion that there is a safe haven for investors. When there is no safe haven, market corrections when they happen will not follow predictable patterns. Historically, when stock prices have plunged, investors have sought out US treasuries, pushing down yields and prices. But what if government securities are viewed as risky? Is it any surprise that the loss of trust in governments that has undercut the perception that they are default-free has also given rise to a host of other investment options, each claiming to be the next safe haven. While my skepticism about crypto currencies and NFTs is well documented, a portion of their rise over the last 15 years has been driven by the erosion of trust in institutions.
Conclusion
I started this post by noting that we pay little attention to risk-free rates in theory and in practice, taking it as a given that it is easy to estimate. As you can see from this post, that casual acceptance of what comprises a risk-free investment can be a recipe for disaster. In closing, here are a few general propositions about risk-free rates that are worth keeping in mind:
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