An introduction to risk-free bonds and risk-free rate

QuietGrowth - An introduction to risk-free bonds and risk-free rate

Risk-free bonds are a theoretical concept in finance, referring to an investment that guarantees return without any risk of financial loss. The idea is that the bond issuer has a 100% probability of fulfilling their debt obligations, meaning that the investor will receive the agreed interest payments and the return of the principal at maturity.

In practice, no investment is entirely risk-free, but some investments are considered close to risk-free. The closest real-world examples are typically government bonds issued by financially stable countries. For example, US Treasury bonds are often used as a benchmark for a risk-free rate in financial models because the US government has never defaulted on its debt obligations.

However, even government bonds of financially stable countries have some risk of default. Nevertheless, the risk is considered to be so minuscule as to be negligible for most practical purposes. The financial stability and strong economy of these countries make it extremely unlikely that they would default on their debts.

So, while no bond is genuinely risk-free, some are considered very low risk and are often used as a benchmark for a risk-free rate in various financial calculations and models.

Risks in risk-free bonds

Despite their label, so-called risk-free bonds are not entirely devoid of risk. They carry certain types of risk that investors must be aware of. Two primary risks include inflation risk and interest rate risk.

  • Inflation risk: It is also known as purchasing power risk. It is the risk that the returns from the bond will not keep up with inflation. In this case, even though the investor receives the promised interest payments, the real value of those payments is eroding due to inflation. Therefore, the investor’s purchasing power decreases over time, which can be a significant concern in high-inflation environments.
  • Interest rate risk: It pertains to the susceptibility of a bond’s price to changes in interest rates. When interest rates rise, bond prices fall, and vice versa. This means that if an investor needs to sell a bond before its maturity and interest rates have risen, she might have to sell it at a discount, incurring a capital loss.

Role of risk-free bonds in financial models

Despite carrying various subtle risks, the concept of risk-free bonds plays a crucial role in financial economics. The return on these bonds often serves as the risk-free rate, a baseline against which the returns of other investments are compared.

The risk-free rate is an essential component of many financial models and calculations. For instance, it is used in the Capital Asset Pricing Model (CAPM), which helps determine the expected return on an investment given its systematic risk. It is also used to calculate the Weighted Average Cost of Capital (WACC), which helps firms understand the cost of their different capital sources.

Maturity period of US Treasury bond used as risk-free bond

The specific maturity of a US Treasury bond used as a proxy for a risk-free bond can vary depending on the context or the specific financial model being used.

For very short-term financial decisions, the yield on a 3-month Treasury bill might be used.

For many calculations, the yield on a 10-year US Treasury bond is used as a proxy for the risk-free rate. This is because the 10-year bond is highly liquid and provides a reasonable timeframe for many investment horizons.

In other situations, different maturities may be used. For instance, in calculating the equity risk premium, the yield on a long-term government bond, such as a 20-year or 30-year bond, might be used.

In essence, the choice of which bond’s yield to use as the risk-free rate often depends on the timeframe of the investment or project being evaluated.

Real risk-free rate

The “real” risk-free rate is the return on an investment that is expected after adjusting for inflation. It’s the theoretical return an investor would expect from a risk-free investment, such as a government bond, after the effects of inflation have been factored in.

In other words, it’s the rate of return that an investor would expect to earn above the rate of inflation, allowing for an increase in the purchasing power of their investment.

The formula for the real risk-free rate is:

Real risk-free rate = Nominal risk-free rate – Expected inflation

For example, if a government bond has a nominal return of 5% per year and the inflation is 2% per year, the real risk-free rate would be 3% per year. This suggests that the investor’s purchasing power increases by 3% due to the investment.

The real risk-free rate is a theoretical concept as all investments carry some risk, and rates of return can’t be known with certainty in advance. Additionally, the actual inflation rate can vary from expected inflation, changing the real return.

It’s important to note that the real risk-free rate is not fixed and can change based on monetary policy and economic conditions.

Related information

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