A key concept in the theory of finance is the risk-free rate of interest, a rate that an investor can achieve at zero risk of a loss. It is the minimum return to compare with the higher expected returns on risky assets, such as equities. It plays a key role in the capital asset pricing model (CAPM), which is the most widely used way of estimating the return that a rational investor would need, to be compensated for taking the risk of owning an asset. In practice, the risk-free rate of return is what you would get for holding the bonds issued by a very creditworthy nation state.
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When economists talk about risk and return, we think of risk in a particular way, which is the volatility of returns around some average or mean return. Equity shares, otherwise called stocks, are risky in the sense that their returns are volatile from year to year. The reason for this volatility is that the actual cash returns from equities, namely dividends, are by no means certain, and in some cases may not arise at all. Sometimes equity shares lose all of their value and the return is minus 100%, meaning a complete loss of capital.
But in other cases, the shares of a company may rise dramatically, if that company has great success and can then pay high and rising dividends to the lucky shareholders.
Government bonds, at least where we’re talking of governments that have financial credibility, should have none of this risk. A typical government bond would be a promise to pay £100 in ten years, with coupon payments every six months of £2. That means the total coupon or interest payment would be £4 a year, a simple rate of return of 4% (simple because it doesn’t take account of the time value of money, but that’s not important for today). If the government that issued the bonds is highly creditworthy, then the payment of those cashflows can be regarded as, in effect, risk-free. The rate of interest on any such bonds is therefore called the risk-free rate.
Governments have not always been creditworthy. The English King Edward III borrowed heavily in his wars against France, starting a series of conflicts that were later to be called the Hundred Years’ War. In the 1340s he borrowed from some wealthy families in Florence, then probably the richest city in Europe, where a new form of financial capitalism had arisen. But Edward failed to repay his debts and those Florentine businesses that had lent to him went bankrupt.
Much later, in the 17th century, constitutional changes made England the most creditworthy nation in Europe, and it was able to borrow large sums to fund another war with France (you can see a pattern here perhaps) but this time, and ever since, the funds were repaid. English, and later British (*), government debt became seen as free of default risk: investors were highly confident they would get both the interest payments and the eventual return of their capital.
Today, British government creditworthiness remains pretty good, but it is the US government whose debt is the global benchmark for zero default risk. Private investors all over the world, even other countries and their central banks, willingly buy US treasury bonds and bills, for funds that they regard as too precious to lose.
(Note that bills refers to short term borrowing, and bonds refer to long term. The US also uses the term notes to refer to medium term borrowing but most other countries and indeed most investors just refer to bills and bonds.)
Risk-free means no default risk – but there is still market risk, and inflation risk
So, what do we mean by saying that US government debt is risk-free? Does it mean that if you buy a US government bond in the market you face no risk of loss?
1. Market risk
Not quite. If you buy a government bond and hold it to maturity, meaning the date when the capital (what we call the principal) is repaid, then you face no risk over the cashflows, which you will receive with near certainty.
But if you buy the bond in the market and for some reason sell it before maturity, you may make a profit or a loss. This is because the price of bonds, like any other financial asset, varies over time as interest rates vary. This is because of the discounting effect, another application of the net present value approach to valuation.
In owning a US government bond, you own a stream of future cashflows, which are fixed with near certainty. But the net present value of those cashflows depends on the current interest rate. Why? Because that is the opportunity cost of your capital. At any time, you could in theory sell your bond and put the funds instead into some other investment of equivalent risk. If that alternative investment is a better use of funds, because it offers a higher net present value, then you would be wise to do so. The opportunity cost of capital in turn depends on market interest rates, which vary constantly every day.
So, if you buy the bond and then interest rates rise, the value of those fixed cashflows should now be discounted at a higher rate: the net present value has fallen, and so will the market value of the bond. If you then sell at that point, you will suffer a loss.
This risk, of changing interest rates affecting the value of the bond before maturity, is called market risk. Any financial asset is subject to this, because changing interest rates means changing net present values for any stream of cashflows. It gives rise to the well established fact that when interest rates rise, bond values fall and when interest rates fall, bond prices rise.
2. Inflation risk
There is one more risk that applies, even to US government bonds, which is inflation. Apart from some bonds whose value is explicitly tied to inflation (**), the majority of bonds, whether government or corporate bonds, pay cashflows in nominal terms. That means that the real value of those cashflows depends on inflation. At a moment in time, the market will price them according to prevailing expectations of future inflation. If inflation expectations rise, meaning that the market now expects higher inflation than before, then those bonds will be worth less than before, because their net present value in real terms will fall.
So, we need to be careful about saying that there are truly risk-free assets. You can’t just buy US or German or British government bonds and assume all will be fine. If you hold them to maturity, you should indeed get a pretty certain stream of nominal cashflows. But if you sell them in the market before that point, you may suffer a loss on your investment. And even if you do hold them to maturity, if inflation rises above what was previously expected, then the real value of those cashflows will be less than you expected.
But you should be confident that you will indeed get your money back at least in nominal terms, which is not the case for equity shares, or real estate or any other risky assets.
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(*) England, which included Wales, was a separate country from Scotland (though they shared a common king) until 1707, when the two were merged into what became officially known as Great Britain. In 1801 the island of Ireland, formerly a colony of Great Britain, was officially incorporated into what then became known as the United Kingdom of Great Britain and Ireland. With the majority of the island of Ireland achieving independence as the Irish Free State in 1922, the name was amended to the United Kingdom of Great Britain and Northern Ireland, which it remains today. So the sovereign borrower went from individual kings of England, to the Kingdom of England (the constitutional monarchy), then the country of Great Britain, and finally to the United Kingdom.
If this isn’t complicated enough, there are also Crown Dependencies, namely the Channel Islands and the Isle of Man, which are neither sovereign states, but nor are they part of the UK; and fourteen British Overseas Territories, which include Bermuda, the Cayman Islands and British Virgin Islands, which are also neither sovereign states nor part of the UK. Note how many of these entities are offshore financial centres, benefiting from UK legal practice and connections to London, but separate tax status.
(**) Most advanced economy governments issue inflation-linked securities. In the US these are called Treasury Inflation-Protected Securities or TIPS.
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