When ’Risk-Free’ Isn’t

It’s no secret that the US economy faces  a mounting debt load and anaemic growth prospects. But one inevitable consequence of this challenging economic environment is often overlooked despite having far-reaching implications for the world of finance: the loss of US government bonds’ risk-free status.

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 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 confirmed 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 modeling, forecasting and evaluation of asset and liability prices, cash flow valuations and risk.

For more than half a 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. US Treasury debt, likewise, served as quasi risk-free assets in finance and commerce in the US and globally.

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

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.

Treasuries and money market fund alternatives to unencumbered cash

To the extent that the short-term debt obligations of the US 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 Federal Deposit Insurance Corporation (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” (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 the 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, a lack of transparency in intra-month money market fund holdings  still contributes uncertainty to default and liquidity risks.

Other alternatives to unencumbered cash also carry default risk or default-contingent market risk.

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