The “Risk-Free” Rate

Posted by on 03/26/10 in Debt, Risk

Margaret Truman once wrote that “Courage is rarely reckless or foolish…courage usually involves a highly realistic estimate of the odds that must be faced.” So what are those odds today?

According to Bloomberg (“Obama Pays More Than Buffett as US Risks AAA Rating” March 22, 2010, Bloomberg.com), the bond market reveals that the debt of major corporations such as Berkshire Hathaway, Johnson & Johnson, and Proctor & Gamble is a safer bet than the debt issued by—brace yourselves now—the US Government. Yes, it’s true.  If you’re going to loan money to someone, says the Market, you’re more likely to get it back at maturity if you loan it to the world’s largest health care company than if you loan it to the world’s now-largest health care agency.

What it also says is that the AAA-rating on US Treasuries is disconnected from how US Treasuries are actually trading. Berkshire Hathaway has earned a Moody’s rating of Aa2, while P&G is rated Aa3 (S&P ratings of AA+ and AA-, respectively), yet both companies pay a lower yield to borrowers than do we the taxpayers. We’re not huge fans of the current credit rating system—the one that sold the world on AAA-rated telecom debt in the early part of the last decade and AAA-rated mortgage backed debt toward the end of the decade. Moody’s says that US debt is AAA; the Market says it is closer to AA. Who do you believe?

Besides providing fodder for discussions on political philosophy and economic theory, this shift in the perception of risk of US Treasury bonds has implications for traditional approaches to asset allocation theory. While the topic deserves a more in-depth technical analysis (on which we are working), allow us to share a few key points:

  • Most current asset allocation theory is predicated on first establishing a “risk-free” rate of return. Analysts and advisers then calculate what they consider a forward-looking risk-premium for each asset class that is added to that risk-free rate of return.
  • The “risk-free” rate of return used by most is the 10 Year US Treasury yield, the idea being that such an investment is as close to riskless as the markets afford.
  • If the markets no longer consider the 10 Year US Treasury to be a riskless asset, then how can its yield represent the forward-looking “risk-free” rate of return?
  • If the risk-free rate is NOT the 10 Year US Treasury yield, then what is it?

Yet again, the Great Recession compels investors and taxpayers to reassess long-held truths and assumptions about finance, investment theory, and the role of government. It also reminds us how interconnected these matters are. For even as the US issues an expected $2.4 trillion (yes, that is a “tr”) of debt in 2010 alone, major US corporations sit on a comparable amount of cash. And how do they invest that cash? Well, most of it is invested in a mix of short-term corporate notes and US Treasury bills. It needs to be low-risk, after all.