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Everyone's heard the saying "if it sounds too good to be true, it probably is". Yet in financial markets we talk about 'risk free rates' as if they're actually real. What's the deal?
Let's define 'risk free'. First up, what it isn't 👇
ICYMI, Terra collapsed - their stablecoin wasn't 'stable' at all and the whole debacle resulted in losses of around $42 billion.
Turns out that a product paying 20% yields isn't risk-free. Who could have guessed? If it were, the product wouldn't need to offer 20% yields to attract capital...
Generally speaking, any time an investment offers a supposed risk-free return (especially if that return is exceptional), it's because the risks are hidden, or you haven't figured out what they are yet.
OK, so what's the risk-free rate then?
Whatever I say it is. We'll come back to this.
The risk-free rate is the rate of return offered by an investment that carries zero risk.
Every investment asset carries some level of risk, however small, so the risk-free rate is something of a theoretical concept. In practice, it’s considered to be the interest rate paid on short-term government debt.
All based on the belief that governments won't default. US government debt is considered the benchmark. Among other things, it's the largest economy with the most developed capital markets and widely-used currency.
Despite the recurring debt ceiling shenanigans (next installment is going to be riveting 🥱) the US government hasn't ever (really) defaulted on their debt.
So, we can say that it's based on an assumption that the government won't default on their obligations. Which is reasonable.
In theory, governments have unlimited power to make their payments. They can raise taxes, seize assets, 'print' new currency by issuing new debt, and so on.
However, risk is always present. Recently for example, inflation risk. The currency that's returned to you can be devalued by inflation during the investment period.
If you lend the government your spare cash for a year, are you being adequately compensated for the inflation risk?
If not, are there better risk-adjusted returns available?
Likewise, the mark to market risk. If you bought 10 year bonds at the highs in 2020 and you want to sell before maturity, they're definitely not worth what you paid...
At this point, it gets highly personal. If I have $100k to invest, and you have $100mn to invest, our ideas of risk-adjusted (and the relative attractiveness of bonds) might be hugely different.
What's the answer?
Generally speaking, the entire point of a risk-free rate is to evaluate the risk premium of other investments. And the rate we use depends on which type of investment we're looking at.
Tech companies are a perfect example. Nobody expects to invest in a startup and see returns within a year. So why use a short term interest rate as your benchmark?
It makes far more sense to use the 10 year rate for this. What return could you expect over the next decade by investing in 10 year treasuries?
Roughly 4% per year at current pricing.
That's the starting point. Then you want some kind of premium to compensate you for the added risk you're taking by investing in the young company.
If all goes well, that startup could become very valuable, but it could also fail, meaning you lose the majority, or all, of your investment.
The higher the risk, the higher the potential return. Likewise, the higher the variance of the potential return. Death or glory, all or nothing.
Like this 👇
Government bonds usually offer capped returns and capped losses. It's very hard to lose all of your capital in the main government bonds. It's also very hard to make mega returns. That's the purpose they serve.
The whole point of taking risk is the expectation of a superior return.
Superior to what? It's all a matter of perspective...
Over to Howard Marks 👇
This is the essence of investment risk. Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money.
These investments are undertaken because the expected return is higher.
Potential opportunity costs - the result of missing opportunities - usually aren't taken as seriously as real potential losses. But they do deserve attention. Put another way, we have to consider the risk of not taking enough risk.
And the best way to vaguely quantify that is to compare prospective returns to the least risky assets. Calling this rate "risk-free" is just plain wrong, and probably came from some Edward Bernays style marketing genius along the way.
Marks also captures the dichotomy of risk-taking perfectly in this snippet:
In the early 1980s, a reporter asked me, “How can you invest in high yield bonds when you know some of the issuers will go bankrupt?”
Somehow, the perfect answer came to me in a flash: “The most conservative companies in America are the life insurance companies.
How can they insure people’s lives when they know they’re ALL going to die?”
These two Marks Memos on risk are superb if you want to dig deeper 👇
Summing up, Risk always has a price. Sometimes that price is too high, others it's too low. Annoyingly, that price is constantly changing too. But nobody forces us to play the game.
Our job is to take intelligent risk. Stack the odds in our favour as much as possible, accept that the future is unknowable, and do it anyway...
“... you need comfort that the risks and exposures are understood, appropriately managed & made more transparent for everyone...
This is not risk aversion; it is risk intelligence.”
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