Coping with the loss of safe haven investments

It’s no secret that the US economy is challenged by a massive debt load and anemic growth prospects. But one inevitable consequence of this economic environment is often overlooked. The loss of risk-free status by US government bonds has far-reaching implications for the world of finance.

Efforts to source “risk-free” reference rates and investment vehicles will extend beyond US Treasuries to a much wider range of issuers. Cash management practices will change, as will the sources, management and valuation of collateral. The expression and valuation of assets, liabilities and cash flows on balance sheets will be affected, as will the application of capital allocation models.

What Is “Risk-Free”?

Conceptually, “risk-free” rates of return result from cash flows associated with debt instruments entirely lacking in default risk.

In theory, treasury paper issued by governments operating fiat currencies is risk-free because such issuers are at liberty to print currency to meet their obligations. In practice, however, debt instruments entirely free from default risk have never existed because, even for those operating under fiat currency regimes, issuer choice and structural impediments can lead to default. The recent “game of chicken” in the debate over the US debt ceiling unambiguously confirms this reality.

Yields associated with all debt instruments, including US Treasuries, consist of a “pure” interest rate component, entirely free of default risk, and a default risk premium component. But even though no debt instruments are entirely free of default risk, historically some have been assumed to be so.

“Risk-free” rates of return serve as critical inputs in the modelling, forecasting and evaluation of asset and liability prices, cash flow valuations and risk. For more than a half-century, the default risk premium component of yields for US Treasuries was perceived to be nearly zero and US Treasury yields served as the global risk-free rate proxy. In the physical world US Treasury debt, likewise, served as quasi risk-free assets in finance and commerce in the US and globally.

The Growing Debt Burden

Considerable leverage has been accumulated in the US over the last three decades, via both private and public debt, and a relatively short maturity profile for outstanding debt has emerged.

While concurrently falling interest rates have enabled debt servicing loads to remain modest, the volumes of debt needing to be rolled over or newly issued in the next decade suggest extreme sensitivity to interest rate rises. Even a moderate rise in rates would dramatically increase US debt-servicing burdens.

Investable “Risk-Free” Instruments And Yields

As no debt instrument is entirely free of default risk, the only truly risk-free investment vehicle is unencumbered cash.

Cash held in a truly unencumbered form cannot be lent, counted as balance sheet capital, pledged as collateral, or otherwise claimed by a party other than its owner and, accordingly, cannot earn interest. Consequently, the only truly investable risk-free yield is zero. If a custodian (rather than a mattress) is utilised to hold cash in an unencumbered form the owner will, most certainly, incur custodial fees. Therefore the effective investable risk-free rate or yield, net of custodial fees, is negative.

If held in local currency, unencumbered cash is free of exchange-rate risk but cash holdings do, of course, carry inflation risk.

Treasuries And Money Market Fund Alternatives To Unencumbered Cash

To the extent that short-term debt obligations of the US Federal government can be regarded as “very nearly” risk-free (a condition that might not, at times, hold in the future), it may be reasonable to regard FDIC-insured money market funds and FDIC-insured certificates of deposit (up to applicable coverage limits) in a similar default-risk light.

Neither fund sponsors nor the US government guarantees against the risk of money market holdings, not covered by FDIC insurance, “breaking the buck” (i.e., failing to maintain par redemption value). Were it faced with a systemic breakdown in capital markets in the future, it is uncertain whether the US government could or would extend a safety net to non-FDIC insured money market funds, as it did in 2008-2009. It is also uncertain whether insurance coverage provided by some fund sponsors would prove reliable in the face of a broad, systemic crisis.

Despite significant reporting requirement enhancements to the Investment Company Act made effective in December 2010, the lack of intra-month money market fund holdings transparency still contributes uncertainty to default and liquidity risks.¹ Other alternatives to unencumbered cash also carry default risk or default-contingent market risk.

Risk, Yield And Liquidity Preferences

Within a given interest rate and credit risk environment, investor allocation decisions among cash alternatives are driven by the relative importance of yield, liquidity and principal protection objectives and preferences.

Where risk-free unencumbered cash is an actionable alternative, a decision to hold currency in a form other than unencumbered cash represents a choice to trade the risk-free negative effective yield of unencumbered cash for a yield comprised of a risk-free interest rate and an inseparable default risk premium associated with the debt instrument of a given issuer.

In general, where yield considerations figure most prominently, higher-yielding money market funds lacking a Treasury orientation are likely to figure prominently. Where principal protection and liquidity are most important, short-term Treasuries (provided they can, at the time, be regarded as “very nearly” risk-free), FDIC-insured holdings and/or unencumbered cash (if available) are likely to play a larger role.

For most US investors and asset managers, risk distinctions among cash and cash alternatives were, until recently, relatively unimportant. However, the assessment of default risk among cash alternatives will take on increasing importance in this era of elevated sovereign risks.

At present, many investors and risk managers would find it difficult to allocate a portion of their “cash” holdings to a fully unencumbered cash form (this would apply to cash holdings in bank accounts over and above FDIC coverage limits, or holdings surplus to those in already low-yielding Treasuries) due to a lack of such offerings in explicit and definitive form by custodians.

Current Yield Spreads And A Hypothetical (Higher) Risk-Free Rate Environment

The potential role for unencumbered cash is greatest in low yield environments. Yields on short-term US Treasury and money market funds have collapsed since the onset of the financial crisis in 2007 and for three and six-month Treasuries have, at times, turned negative. With low yields for incrementally risky assets, yield spreads to truly risk-free unencumbered cash have also collapsed.

We’ll assume (for illustration purposes only) that custodial fees for unencumbered cash stand at 0.08% per annum, resulting in an effective yield on unencumbered cash at negative 0.08%. Also assume (for illustration purposes only) that the default risk premium component associated with three-month US Treasuries is 0.01%.

At the time of writing this, total yields on three-month US Treasuries and on US money market funds were approximately 0.02% and 0.04%,² respectively (Bloomberg, 20 October 2011; Crane 100 Money Fund Index, Crane Data, 20 October 2011). This would imply a 0.01% risk-free interest rate component and a default risk premium of 0.03% for money market funds (i.e., 0.04% total yield – 0.01% risk-free interest rate = 0.03% risk premium).

In the present interest rate and default risk premium environment, total yield compensation gained through non-cash alternatives is relatively low, owing to the currently near-zero interest rate component of total yield. Against the assumed negative 0.08% yield for unencumbered cash, yield spreads to three-month Treasuries and money market funds are only 0.10% and 0.12%, respectively. An investor or risk manager foregoes 0.09% of risk-free interest plus a 0.01% or 0.03% default risk premium to place capital in unencumbered cash rather than short-term Treasuries or money market funds, respectively.

Consider, now, a hypothetical environment in which default risk premium components remain unchanged but short-term risk-free interest rates are 3.00% higher. Total yield for three-month Treasuries and money market funds become 3.02% and 3.04% respectively. Yield spreads relative to risk-free, which the investor or risk manager foregoes when allocating to unencumbered cash, become 3.10% and 3.12% respectively.

Because the “cost” of allocating capital to unencumbered cash rather than to a cash alternative is equal to the total yield spread, it “costs” far less to eliminate default risk completely in a low interest rate environment than in a high interest rate environment, ceteris paribus. In the hypothetical, higher risk-free interest rate environment, the total yield trade-off for shedding default risk by parking in unencumbered cash is far greater (by 3%) than in the current, low interest rate setting.

A Floor To Debt Yields?

Given the choice, a rational investor will park capital in unencumbered cash whenever yields among risky debt alternatives are equal to or less than the yield on risk-free unencumbered cash. Consequently, in a market where capital can be freely allocated, the effective yield on unencumbered cash would function as a yield floor to debt instruments of all types and maturities.

While unencumbered cash-holding format offerings by custodians are currently limited, increasing default risk concerns and a persistently low yield environment are constructive to demand for holding cash in an unencumbered form.

The yield floor-effect and capital flows arising from unencumbered cash carry important monetary policy implications. As yields on risky debt approach the yield on risk-free unencumbered cash (they are within roughly 0.10% as of 20 October 2011), capital will flow from debt instruments to idly-stationed, unencumbered cash—effectively reducing money supply.

It is worth noting that certain, arguably “extreme,” policy responses (e.g. broad application of Irving Fisher’s “stamp scrip” or other forms of tax on cash holdings) would dramatically alter interest rate dynamics and theoretical boundaries, such as the yield floor. While not contemplated in this paper, given the current environment (exhibiting price, yield, volatility, liquidity, political and policy extremes globally), consequences of extreme policy responses are deserving of considerable thought and attention.

“Risk-Free” Rate Proxies

That the US dollar may serve as the world’s reserve currency for years to come is rather a sign of the scarcity of alternatives than confirmation of a truly risk-free default status. We now live in a world lacking debt issuers which can, beyond the relative short term, be regarded as “very nearly” risk-free.

Going forward, asset, liability, cash flow and risk pricing and modeling exercises will derive risk-free rates from an evolving subset of the global government bond universe. Suitable issuers will have relatively healthy balance sheets combined with stable political, fiscal and monetary regimes. At present, the pool of issuers comprising this subset is rather short in supply.

Over time, we can expect the focus of this “reference basket” to move away from the highly leveraged, increasingly unstable economies which dominated 20th century capital markets, and towards the relatively few structurally healthy, politically stable developed economies and several of the rising and relatively healthy emerging economies.

Across the maturity spectrum, the role and importance of US Treasuries in this reference basket will vary according to the country’s economic and political standing. The role of US Treasuries as a nearly “risk-free” proxy for rates and investable debt will likely apply to shorter maturities than in the past.

Portfolio Theory: Models And Practical Applications

Financial models whose primary outputs do not include capital allocations to “risk-free” assets will be little impacted by the removal of risk-free status from US Treasuries. The Dividend Discount and Black-Scholes Option Pricing models, for example, use risk-free rates primarily for the derivation and evaluation of risk premiums and as inputs in processes seeking to value and price assets, rather than as a means of determining capital allocations to “risk-free” assets.

Conversely, models whose primary outputs include capital allocations to “risk-free” assets may be significantly impacted by mounting sovereign risks. The Capital Asset Pricing Model (CAPM), for example, assumes unlimited borrowing (leverage) and lending capabilities at “risk-free” rates. Lending takes the form of capital allocation to “risk-free” Treasuries earning “risk-free” rates of return.

In this age of rising and shifting sovereign risks, “risk-free” rates and debt must be conformed to default-risk realities and, where applicable, investors’ risk-carrying capacity.

Capital And Collateral Matters

Once past the fiction of static valuation of risky assets at par or book value, financial institutions one day will “care” more meaningfully about what are presently unrecognised divergences from reality in the quality and value of their balance sheet entries. Whether driven by capital markets, regulators or accounting policy authorities, debate regarding what constitutes “risk-free” will play a central role in shaping the pricing verdicts ultimately rendered in the marketplace.

In the meantime, it is likely that capital markets will increasingly rely on a broader and evolving selection of collateral to secure positions in futures, derivatives and other markets. Valuations of US and non-US Treasuries, non-treasury debt, precious metals, and other commodities and assets as collateral will be fluid.

Implications

The macro backdrop of the quarter century leading up to 2008 lent inertia and a false sense of comfort to long-entrenched thinking about default risk. The fact that, beyond relatively short maturities, “nearly risk-free” can’t be had via any debt instrument on the planet is only beginning to sink in across the financial landscape.

Estimates of risk-free interest rates will continue to remain important to the valuation, pricing and discounting of assets, liabilities and cash flows—even as the sources of those risk-free rates evolve. Investment and risk management involving cash and cash alternatives will experience important transformations in thinking and practice, as a reevaluation of what constitutes “risk-free” takes place amongst the financial community.

Default risks associated with alternatives to unencumbered cash are no longer benign, no longer irrelevant, no longer (seemingly) static. Going forward, differences in absolute and relative riskiness of cash alternatives are likely to become more pronounced.

In summary, investors and asset managers face a significant new challenge: allocating capital and managing risk in an environment without “risk-free.”

Footnotes

1. Securities and Exchange Commission, [Release No. IC-29132; File Nos. S7-11-09, S7-20-09], RIN 3235-AK33, “Money Market Fund Reform,” 5 May 2010, pp. 201-2. Prior to implementation of these changes, rule 2a-7 of the Investment Company Act of 1940 required quarterly reporting of holdings, up to 60 days in arrears. Holdings reports for funds reporting per the schedule, consequently, were two to five months stale at any given time. With the 2010 amendments, holdings reporting is required monthly, up to five business days in arrears. Holdings reports generated per the revised schedule will range from one week to one month plus one week stale at any given time—a significant reduction both in reporting interval and lag. But with weighted average maturity of holdings capped at 60 days and a minimum 30% of assets required to be “weekly liquid” (purchases of new holdings must not push the figure below 30%), a considerable portion of holdings are necessarily turned over at shorter than one-month intervals. The periodicity of money market fund holdings reporting (when compared with funds’ average maturity) still renders assessment of fund risk problematic, as intra-month portfolio composition is not knowable via disclosures generated per the revised reporting requirements.
2. Low yield environments place extraordinary pressure on money market fund management fees. According to the Investment Company Institute, average money market fund industry expense ratios fell from 0.33% in 2009 to 0.26% in 2010 (Investment Company Institute ,“In 2010, Stock Fund Expense Ratios Dropped; Bond Fund Expense RatiosWere Flat,” 24 March 2011). So long as money market fund yields remain near zero, management fee compression and fee waivers (and negative fund operating margins) will necessarily continue to be the norm in order to maintain par redemption values for fund shareholders. This strained environment may heighten incentive for fund managers to consider potentially marginal risk vs. yield tradeoffs.

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