Investors rethink risk-free return

With Europe in crisis and the US staring down the barrel of default, many investors are asking the same question: What ever happened to the risk-free rate?

By TheStreet Staff Jul 18, 2011 12:58PM

By Niamh Sweeney, TheStreet

 

A key investment measure for everything from pension funds to hedge funds -- the risk-free rate of return -- is being pummeled by the threat of a U.S. debt default and the European sovereign debt crisis.

 

Once a cornerstone of investment management, the notion of a risk-free rate is no longer a given for many investors, and that is prompting strategists everywhere to reconsider old assumptions about the so-called haven of investments.

 

For many years, U.S. Treasurys served as a benchmark -- essentially a default-free entity -- against which investors could measure returns for taking on greater credit risk in global markets. Similarly, the German bund became a proxy for risk-free return in Europe.

 

But what happens when there is no benchmark or when that benchmark becomes as risky as the rest?

'"One thing is now very clear: government bonds are no longer the risk-free assets they once were," declared IMF economist and former deputy governor of the Bank of Spain, Jose Vinals, in a recent blog post.

 

The consequences for investors are potentially enormous.

 

Aswath Damodoran of the Stern Business School at New York University has said the net effect could be to make everybody substantially more risk averse, which would lead to much higher borrowing costs for companies. This would have the dual effect of making companies both more reluctant to borrow, and less likely to pay out dividends.

 

From there it's not difficult to see how robust economic activity would be stymied.

 

While we are not quite there yet, there are difficult decisions facing both the individual investor and those managing vast fortunes, from pension to hedge funds.

 

"The bottom line is you shouldn't regard anything as risk free," says Robert Hayes, head of client strategy at Blackrock's Multi-Asset Client Solutions group. "If you're a long term, liability-based investor like a pension fund or an insurance company, you need to think what your least-risk matching asset is, and any investment strategy should be based on judging how much risk to take relative to that risk-free asset to generate additional return. The challenge is when government bonds obviously contain risk. It's difficult to say what the benchmark is."

 

Earlier this year Standard and Poor's put the long-term outlook for U.S. government debt on negative watch. Moody's has also warned that the U.S. and the U.K. are more prone to a financial shock because of the high interest payments on their debt. Both countries still maintain the coveted AAA rating, but they've been told that that may change. Meanwhile, several other countries, including Switzerland, Sweden, Japan and even Germany, today boast lower yields -- and, by inference, less risk -- for their debt.

 

Head of bond strategy at CRT Capital David Ader says that, despite all that, U.S. Treasurys are still the only legitimate way to measure risk. "As a benchmark, there's not a whole lot else out there that would possibly fit. The patient is ill but we can still detect a pulse."

For others, U.S Treasurys still serve as the "gold standard" of sovereign debt. Alan Zafran of Luminous Capital says the U.S. Treasury bill is still a risk- free asset in the traditional sense. In other words, he doesn't believe that the U.S. will default. "But that's on an un-hedged currency basis," he says. "If I believe the U.S. dollar will decline in time, then the notion of it being risk free is a flawed concept."

 

With inflationary concerns competing with rock-bottom interest rates and sovereign credit questions, some investors are choosing to avoid countries all together and opt for corporate credit, where yields and spreads are higher. "A lot of people trust companies more than they trust countries," Asoka Wöhrmann, chief investment officer at the Deutsche Bank-owned DWS told the Financial Times recently.

 

Richard Robb, a co-founder of New York hedge fund Christofferson, Robb & Co., takes a balanced view. "Is there some chance that anything is going to default? Of course there is. People are just being reminded of something that's always been true."

 

"U.S Treasurys are not a safe haven, but they are going to pay it eventually, in my opinion. I can't imagine a period of time where they wouldn't. I don't think there's any doubt about that."

 

Related Articles

0Comments

DATA PROVIDERS

Copyright © 2014 Microsoft. All rights reserved.

Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.

STOCK SCOUTER

StockScouter rates stocks from 1 to 10, with 10 being the best, using a system of advanced mathematics to determine a stock's expected risk and return. Ratings are displayed on a bell curve, meaning there will be fewer ratings of 1 and 10 and far more of 4 through 7.

113
113 rated 1
279
279 rated 2
416
416 rated 3
647
647 rated 4
548
548 rated 5
513
513 rated 6
669
669 rated 7
516
516 rated 8
317
317 rated 9
113
113 rated 10
12345678910

Top Picks

SYMBOLNAMERATING
KOGKODIAK OIL & GAS Corp10
UPLULTRA PETROLEUM Corp10
TAT&T Inc9
COPCONOCOPHILLIPS9
DVNDEVON ENERGY CORPORATION9
More

VIDEO ON MSN MONEY

ABOUT

Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.

Contributors include professional investors and journalists affiliated with MSN Money.

Follow us on Twitter @topstocksmsn.