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Beyond the Ceiling: Rethinking the Risk-Free Rate

Today's post is by Roger Loh Kit Seng, the Director at Mazars Malaysia, providing firm-wide technical guidance on various financial modelling, valuation and financial reporting issues. Roger was involved in multiple valuation assignments for various industries, including consumer, energy, financial services, healthcare, infrastructure, luxury, real estate, technology, and transport & logistics.

On the eve of an unprecedented default deadline, President Biden signed the "Fiscal Responsibility Act of 2023." The act pulled the nation back from the brink of a financial debacle following months of negotiations. Biden declared "crisis averted," hailing the bipartisan effort that warded off the default and further secured social programs like Medicare, Medicaid, and Social Security. However, amid the close call with the default, it compels us to wonder: Can U.S. sovereign bonds continue to provide a safe investment, regardless of political uncertainty?

Overview of Risk-Free Assets and Risk-free Rates

“Traditionally, U.S. sovereign bonds (especially Treasury bonds, notes, and bills) have been regarded as nearly "risk-free assets", backed by the full faith and credit of the U.S. government. "Risk-free assets" refer to financial assets assumed to be free from financial risk, in which the issuer is highly unlikely to default on the obligation, while “risk-free rates” represent a theoretical return on investment without financial risk. Both are hypothetical constructs, as all investments carry some risks.”

Grounds for the Presumption

Here are several rationales behind U.S. sovereign bonds to be commonly regarded as nearly risk-free assets:

• The U.S. boasts one of the world's largest and most stable economies, significantly decreasing the likelihood of defaulting on debt obligations.

• The U.S. has monetary sovereignty, meaning it controls its currency, the U.S. dollar. Theoretically, the U.S. can always satisfy its debt obligations by creating more money.

• The U.S. dollar is a global reserve currency held significantly by governments and institutions as part of their foreign exchange reserves, providing additional financial stability and borrowing power to the U.S.

• The U.S. has historically proven to be reliable in meeting its debt obligations for many years, enhancing confidence in its future.

For these reasons, the yield on U.S. Treasury securities has been used as a proxy for the risk-free rate based on conventional wisdom. Though the U.S. government bonds are broadly considered "risk-free," they are not entirely devoid of danger. This reality is underscored by the recent debt ceiling crisis that these bonds carry some degree of risk, thus challenging the conventional notion of what constitutes a risk-free asset.

Revisiting the 2011 Credit Rating Downgrade

“The U.S. government has historically enjoyed from credit rating agencies the triple-A ratings, also known as the "gold standard," the highest level of confidence shown in a country's ability to meet its financial obligations. However, during the debt ceiling crisis in 2011, the U.S. experienced a historical financial event—a downgrade in its credit rating from AAA to AA+. For the first time, S&P Global Ratings, one of the Big Three credit rating agencies, lowered the country’s credit rating with a negative outlook.”

The downgrade resulted from contentious negotiations over the debt ceiling, which raised concerns about the government's fiscal stability and political climate. Following the downgrade announcement, all three major U.S. stock indices dropped five to seven percent in one day.

Fast forward to the debt ceiling crisis 2023, Fitch Ratings Inc. stated that in the event of a default, affected securities could be downgraded from AAA to "D", while other Treasury bills could fall to "CCC" or "C". Though the default scenario has been averted now, the potential of a default poses a devastating situation.

Questioning the Risk-Free Rate: Damodaran's Perspective

Aswath Damodaran, a finance professor at New York University, defined a risk-free asset as an asset without default and reinvestment risks. While he agrees there are no assets without reinvestment risk, some governments can be considered default-free entities.

Damodaran advocates the consistency principle, where the choice of the risk-free rate should be matched with the currency of the cash flows used. He argues that the difference in interest rates (in this case, risk-free rates) reflects differences in expected inflation. Therefore, a low discount rate arising from a low risk-free rate will be offset by a decline in an expected nominal growth rate for cash flows, and the value will remain unchanged.

He also recognises that not all governments are default-free, as evidenced by different credit ratings across countries, so he has introduced a solution by adjusting the sovereign bond yield with a default spread. In most cases, the default spread is based on the credit ratings assigned by the Big Three.

Reconsidering the Risk-Free Rate

In most authoritative texts or journals, U.S. securities yield is suggested as a proxy for risk-free rates. As of the time of writing, this notion is still rendered valid for the aforementioned reasons. Although the process involved in credit rating evaluation does not provide timely results, this issue can be addressed by using the traded value of a credit default swap (CDS) on selected U.S. securities.

CDS is a form of insurance against the default of loan security. When a buyer buys a CDS, the seller agrees to compensate the buyer in the event of a loan default by the loan security. For illustration, a five-year Treasury bond yielded 3.74% as of 31 May 2023, and the CDS was traded at 49.69 basis points. Therefore, the adjusted risk-free rate was 3.24% after the CDS spread.

Risk-free with Caution

A key takeaway from the recent U.S. debt ceiling crisis is that even government securities are susceptible to political uncertainty and default risk. While the agreement to raise the debt ceiling averted a crisis, it revealed the fragility of financial markets and the interconnectedness of global economies. Therefore, to counterbalance this instability as well as the ever-present looming threat of high inflation, no financial assets are to be considered completely risk-free and evaluations on the appropriateness of the established risk-free rate should be carried out periodically.


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