The current sovereign-debt crisis in Europe is raising long-term questions about some of the bedrocks of finance and investment theory. Namely, are the concepts of a “risk-free rate” and “risk-free assets” still meaningful when the creditworthiness of so many developed countries is under threat?
The risk-free rate of return—or the theoretical rate of return of an investment that has no risk of loss—is one of the most important building blocks of modern finance, appearing in everything from modern portfolio theory to the capital-asset pricing model and the Black-Scholes option-pricing model.
Initially, US Treasury bills were considered the ultimate risk-free asset. This is because of their very short maturity (which insulates them from interest-rate risk) and the very low perceived default risk of the US government. The AAA-rated government bonds of other industrialized countries, such as Germany, the UK and France, were also considered risk free when denominated in their domestic currencies. Certain currencies, most notably the US dollar and the Swiss franc, were also considered to be risk-free stores of value.
Over time, LIBOR—the interest rate that banks charge each other in the London interbank market—also came to be considered the risk-free rate. The swap market is built around the exchange of cash flows from virtually any asset for LIBOR.
But today, fewer assets seem to be risk free.
Most European government bonds and Japanese government bonds no longer appear to be risk free, given their nation’s deteriorating fiscal positions (although German and Japanese government bond yields remain very low). And earlier this year, the Swiss National Bank threatened the safe-haven status of the Swiss franc by drawing a line in the sand with respect to how strong it would allow its currency to be against the euro.
Furthermore, the global financial crisis of 2008 raised doubts about LIBOR’s safety, since it necessarily reflects bank counterparty risk, a type of credit risk. The European sovereign-debt crisis has reinforced these doubts, since many European banks appear threatened by their exposure to the debt of euro-area governments.
While US Treasuries and UK gilts have retained their luster (US Treasury yields are near record lows), if US and UK budget deficits and quantitative easing continue, it should not come as a complete surprise if those assets become tarnished, too. In the US in particular, the huge size and deep liquidity of the Treasury market—coupled with its current risk-free status—may have driven yields below levels that are justified based on pure fundamentals. If the risk-free status of Treasuries ever comes under serious question, the impact on yields could be devastating.
So we’re clearly living in a world with a diminishing number of risk-free assets. What does all this mean? At the very least, it suggests that markets are likely to remain volatile and traditional asset-allocation tools are likely to come under scrutiny. Risk-taking, in the aggregate, will likely diminish, as barbell strategies (which combine high-risk assets with low-risk assets) become less reliable.
Another thing is for sure. The creditworthiness of developed sovereign governments can no longer be taken for granted. Just as for corporate debt and emerging-market sovereign bonds, detailed credit analysis of developed sovereign bonds will be critical.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.