The risk-free rate is a common term in financial equations – it’s a part of everything from the Sharpe Ratio to the (in)famous Black-Scholes equation for pricing options. It’s simple in theory – an investor’s expected return on a risk-free investment, one that’s perfectly safe.
In theory. But where to get such “safe” assets in practice… and what does “safe” mean, exactly?
For practical purposes, short-term US Treasuries are generally considered “risk free,” although there is still obviously a small but non-zero chance that the government and economy of the United will disintegrate before maturity. Barring a total collapse, there’s still a chance for capital loss on US bonds if rates rise (making newly-issued bonds more valuable).
We’ve been anticipating just such a fall in bond prices eventually (and we’re far from the only ones). Indeed, the idea that US borrowing costs are going to skyrocket and bankrupt the country has been a popular refrain for the last few years, and is a driving force behind the anti-deficit chorus pushing for spending cuts. Yet despite all of the doomsaying, US interest rates have remained incredibly low. In other words, investors still see US treasuries as a relatively risk-free investment (which, in a sort of manifest destiny, makes it so). The Economist finance blog Free Exchange has an interesting take on this, arguing that this has been largely due to a shortage of safe assets:
…Why would there be a relative shortage of safe assets?
One reason is that people are more aware of downside risk than in the past, thanks to the collapse in middle class wealth and the massive increase in joblessness; there is more demand for safe assets. This is actually healthy and overdue. In fact, there is good reason to think that the process still has a long way to go. The safe asset shortage can also be attributed to the fact that many assets previously thought of as “safe” are no longer seen that way, whether they are Italian government bonds or subprime mortgage securities. Thus, the supply of safe assets declined even as the demand for them soared.
This coincided with some interesting thoughts on the big credit rating agencies from Barry Ritholtz addressing a question we’ve had for years: why does anybody pay attention to the ratings agencies? Well, the evidence suggests that, increasingly, people aren’t. Credit ratings are increasingly being ignored by investors, who have their own ideas about what’s safe and what isn’t. The big three are struggling to play catch-up to the decisions that the markets have already made about creditworthiness. And in large part, those decisions are negative for just about everything other than US treasuries.
What does all this mean? Well, in a world where mortgage-backed securities and Italian debt are no longer considered risk-free, US treasuries are one of the last few remaining “safe” assets around. With QE4 linked to actual measures of economic health (unemployment and inflation), we’ve effectively ruled out a rate hike from the Fed for the forseeable future. And with the creditworthiness of most of the rest of the world still in question, “bond vigilantes” have few alternatives to protect their capital.