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null The Risk of the Risk-free Asset

The Risk of the Risk-free Asset
05 May 2022
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Mark Zuckerberg, the founder of Facebook, once asserted: "In a world that's changing really quickly, the only strategy that is guaranteed to fail is not taking risks."  

So far this year has turned out to be bad for the financial markets.

 Corporate bonds have fallen even further (12%). The US stock market (S&P 500) is down 13% so far in 2022 (tied, however, with last year’s level), with the Nasdaq dropping much further. In turn, the Chinese stock market (CSI 300) is down a whopping 14% since January 1. Traditionally, markets operated by segmenting the level of risk by "steps". Thus, the government bond is considered the "risk-free" asset, which generated a certain return, and as one invested in higher "tiers", additional returns were demanded to compensate for the higher level of risk. The bonds of investment-grade companies (BBB- rating or higher) such as Telefónica, for example, pay a spread over their public counterparts to compensate for the credit risk (the risk that the company, although very solvent, could go bankrupt and default on its bond). In turn, companies that issued "high yield" bonds did so to reflect a riskier rating (BB+ or lower) and, within this universe, the "better" companies (BB rating) pay less than the "riskier" ones (B rating, or CCC or lower). The stock market traditionally provides higher returns than high-yield bonds, and thus well above government bonds, justifying the higher risk inherent in owning stocks (shareholders are the last to get paid after having paid the banks and bondholders). Finally, investment in illiquid assets (such as private equity or private debt) have traditionally generated returns 2% to 3% higher than their liquid counterparts, to compensate for the lack of liquidity, which is obviously interpreted as a higher risk that translates into this higher return.

Analysing the bizarre world we have experienced since the great recession of 2008, it is worth reconsidering some of the fundamentals illustrated in the previous paragraph. If we analyse the government bond, misnamed "risk-free," we find that it has performed at its worst in many decades: people lose money by investing in a "risk-free" asset. The reason is simple: the yield is lower than inflation, i.e. it generates negative real rates (nominal minus inflation), which causes their price to fall to adjust yields. Can this risk be hedged? Not easily, since real rates in the US have gone from -1% to 0.3%, so the prices of almost all assets are tumbling. For many traditional savers, accustomed to considering investing in government bonds as "risk-free", it will have come as an unwelcome surprise to discover the sharp drop in value in these "safe" assets so far this year reflected in their statements. In reality, this is nothing new. During the Second World War, the US Treasury encouraged many American pensioners to invest in "war bonds" with yields of 2% over ten years (rates were set by the Fed at around that level), and yet average inflation of 6% was tolerated. In other words, the investor was losing 4% of his money per year (40% over ten years) on a "risk-free" asset. What is happening today is similar, although with less intensity.

Bank rates

When government bond yields rise, the bank rates at which future cash flows are brought to the present also rise, which generally depresses other assets. Since the US bond has risen since April from 2.3% to levels close to 3%, the poor performance of many markets is unsurprising. When a government bond falls, so do investment-grade corporate bonds, high-yield corporate bonds, and the stock market. Curiously, the performance during the year of high-yield debt (-9% for the US) has been better than that of non-financial investment-grade debt (-9%), despite its higher level of risk (another paradox: the investor who puts his money in apparently safer companies loses more money, due to the high correlation between these bonds and government bonds). In turn, the rise in bond yields causes stock markets to fall, especially the most rate-sensitive stocks. These are the so-called "long-dated" stocks (a very large portion of their valuation corresponds to the long term, which particularly affects the technology sector). It is no wonder that the performance of the Nasdaq (-22%) is much worse than that of other stock markets. Moreover, the fact that technology weighs heavily in the US stock market (S&P 500) and very little in Europe partly accounts for the weaker performance of the US stock market so far this year (as we have seen, a 9% fall compared with a 9% fall in the European DJ Stoxx 600). Finally, for the first time in many years, there has been a synchronised fall between bonds and equities, due to monetary policy, debunking the myth that diversification between the two reduces risk.

However, as Zuckerberg stated, companies and investors are not paid to operate with "the panic room" in mind. In the face of uncertainty, they make decisions; decisions that mark the process of "creative destruction", a process that, paradoxically, ends up generating so much prosperity in the medium term.

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