The concept of a “risk free rate of return” has long been a staple of finance theory and investment practice. Since sovereign governments have abrogated the powers to tax and print money, it has been reasoned that their risk of default – at least among the governments of major, developed-market economies – has been zero. Thus, the “risk free rate” for any given maturity (overnight, three-month, thirty-year, etc.) has been the rate paid by government notes, bills, and bonds. The real “risk free rate” – as opposed to the nominal risk-free rate – also takes inflation into account, so that if a 30-year government bond was paying 5%, but the inflation rate was 2%, then the real “risk-free rate” would be 3%.
The Real Risk Free Rate
The problem: Real “risk free” rates in Japan, the U.S., and the U.K. have been negative for quite some time, and now nominal rates are even being pushed into negative territory. Not only does this destroy finance theory, but it also has serious investment implications: After all, the returns generated by stocks, bonds, and other investments must always be measured against the “risk free” rates of the same maturities or time horizons, since investors need to be compensated for the risks of holding investments that aren’t “risk free.”
This is the subject matter of Research Affiliates’ July 2016 white paper, Death of the Risk Free Rate, by Chris Brightman, CFA. Mr. Brightman also boldly asserts that sovereign debt is no longer free of risk. “Central banks have engineered these negative rates through large scale purchases of securities from the market and the corresponding creation of bank reserves,” says Brightman. “If and when they take the next step of direct money creation, as is increasingly being discussed, long-run risk of inflation will rise.”
In the above quote, Brightman is talking about the quantitative easing (“QE”) programs, under which central banks such as the U.S. Federal Reserve (“the Fed”), the European Central Bank (“ECB”), and the Bank of Japan (“BOJ”) have created new money out of thin air to buy sovereign bonds – and in some cases, private assets as well. The effect of QE has been to push interest rates down, ostensibly to encourage private investment and to boost employment and economic growth, but the effect of the policies has been lackluster.
A Change of Course?
Will the central banks acknowledge their folly and change course? Of course not: Instead, Brightman argues that they’ll use “helicopter money” – direct distribution of newly created cash – which will finally ignite higher inflation and further erode the real returns of all fixed-income assets. That’s because, according to Brightman, the central banks’ true objective is to reduce the real (inflation-adjusted) value of government debt.
But this doesn’t mean that all assets will underperform: According to Brightman’s research, the following asset classes are positively correlated to inflation:
- Bank loans
- High-yield bonds
- Real estate investment trusts (“REITs”)
- Emerging market equities
“The persistence of negative real interest rates across developed cash and government bond markets contradicts our conventional understanding of a risk-free rate,” says Brightman. “Investors should diversify away from government bonds and U.S. equities into higher-yielding inflation-sensitive asset classes such as commodities, bank loans, high-yield bonds, REITs, and emerging market equities.”
For more information, download a pdf copy of the white paper.
Jason Seagraves contributed to this article.