The End of the Risk-Free Rate: Investing When Structural Forces Change Government Debt (PROFESSIONAL FINANCE & INVESTM) - Hardcover

Emons

Hardcover

ISBN 10: 0071819525 ISBN 13: 9780071819527

Verlag: McGraw Hill, 2013

Inhaltsangabe

A NEW FINANCIAL STRATEGY FOR A NEW FINANCIAL WORLD

As an investor, you've probably taken advantage of the risk-free rates in the postcrash economy by putting your money into bonds, stocks, commodities, and currencies. With the rise of government debt across the globe, you can no longer rely on the notion of "safe" to perform asexpected. You need to adapt your investing strategy to a new financial reality.

Filled with expert tips, this step-by-step guide walks you through all of your investment options, showing you how each will be affected by the end of the risk-freerate. You'll learn:

• What you should know before buying bonds and Treasury bills
• How to recognize and invest in the strongest emerging markets
• How to choose between government and corporate options
• What the debt-to-GDP ratio means for you and your investments
• How to evaluate foreign markets in the rapidly changing global economy

With the author's guidance, you'll discover that you don't need to stop investing in government bonds and otherpopular options--you just need to invest differently. You'll learn about combining liquid means, ETFs, mutual funds, and individual securities. You'll gain insights into market depth, liquidity, and capital flows--and how they change depending on regulations, costs, and other factors. You'll see how the debt situations in countries like Mexico and Italy can have an immediate impact on investors around the world. You’ll find new ways to thinkabout investing in a changing economic landscape. Most importantly, you'll learn how to assess risk in different markets.

An essential guide in these fascinating times, The End of the Risk-Free Rate marks a new beginning for today's investor.

Über diesen Titel

Über die Autorin bzw. den Autor

BEN EMONS is a portfolio manager at Pacific Investment Management Company (PIMCO) in Newport Beach, California. He publishes on the PIMCO website (www. pimco.com), in regular publications such as the Global Central Bank Focus (GCBF) and in Viewpoints covering a range of central bank and macroeconomic topics. He is also the author of The Financial Domino Effect.

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The End of the Risk-Free

Rate Investing When Structural Forces Change Government Debt

By BEN EMONS

McGraw-Hill Education

Copyright © 2014 McGraw-Hill Education
All rights reserved.

ISBN: 978-0-07-181952-7

Contents

Cover
Title Page
Copyright
Dedication
A Prelude: Financial Markets Finance
Part I: A Different Financial Universe
Chapter 1: No Longer a True Risk-Free Rate
Chapter 2: Puzzles
Chapter 3: A Way of Life
Part II: Investment Implications
Chapter 4: Some Quantification
Chapter 5: Where and What to Invest In: The "Alternatives"
Chapter 6: Bubble Management
References
Index
About the Author

CHAPTER 1

No Longer a True Risk-Free Rate

When something is "risk free," it is desired—for example, a free lunch, acoupon, or ticket to see a popular show. In financial markets, the economicconcept of a risk-free rate is quite similar. In times of high uncertainty ordistress, market participants want something that has 100 percent probability ofbeing returned to them. The choice is typically cash or what has long beenassumed to be a risk-free instrument, a Treasury bill or government bond.Nothing is truly free in financial terms unless there is a full backstop orsubsidy of some kind. And so government bonds were viewed that way, boringinstruments with a low return because they are public goods. Government bondshave been for a long time in the category of a benchmark for a "safe haven," abeacon of perceived neutrality between risk and return. There has been a changein that definition, known as the "risk-free rate." The onset of the financialcrisis saw large guarantees of their financial systems by governments, and aseconomies fell into a deep recession, automatic stabilizers as well asadditional fiscal stimulus increased governments' total debts. What was normallyconsidered as a steady, boring investment has changed to a volatile instrumentwith credit risk characteristics.

The implications of such a change are vast. Government bonds no longer beingtruly risk-free may change the way markets and academics view the valuation ofrisk premiums for equities; corporate, municipal, mortgage, and agency bonds;and even highly complex structured finance such as collateralized loanobligations (CLOs) and collateralized debt obligations (CDOs). Anotherimplication is that governments' balance sheets fall in the rank of howcorporate balance sheets are valued. A government balance sheet liability is theinterest it pays on its debt. The ability of a government to pay that interesthas been put into question by markets over the past few years, especially forcertain governments in Europe. It is a confidence crisis in public debt. This isnot the first time such a crisis has occurred. Emerging markets have succumbedto the idea of defaulting on their external and internal debt as an easy way outof their economic problems. Other countries, such as Italy in the 1970s, haveused large-scale monetization of debt. The result was currency devaluation thatcaused high domestic inflation, an indirect way of default. The rules of defaultand restructuring were never clearly defined until the Argentina 2001 debtdefault happened. The rules laid out in so-called Collective Action Clauses(CACs) by the G7 working group are now mainstream in Europe. This coulddrastically alter the way markets will price the probability of default or how asovereign restructuring ultimately unfolds. The first test has happened inGreece in 2012. Greek government bonds that were issued with CACs turned out tobe more complicated to restructure than bonds without CACs. This wasspecifically because of the right of investors to disagree with the new terms ontheir bonds through majority voting. Democracy in future debt restructurings maycause dilemmas for governments and policymakers. In a financial world that nolonger operates on the basis of a risk-free rate, the health of the financialsector and governments has a close interconnection. There is an inherent linkagebetween sovereign and financial risks, and the European debt crisis has shownthat such a linkage presents channels of cross-border spillovers. The experienceencourages proactive policies to manage sovereign risk to safeguard financialstability. To that effect, measures are needed to stabilize the banking sector.Done effectively, this can have a favorable impact on sovereign balance sheets.As the notion of risk free has changed, countries with large potentialliabilities from their banking sectors will be continuously scrutinized bymarkets, which will assess if there is a framework in place that identifies,monitors, and reports related risks closely. A government bond market has acrucial role in how a society can function. Government bonds provide funding foreducation, healthcare, law enforcement, and other public goods. The inability toaccess capital markets will affect basic public services and can adverselyaffect the economy.

The Risk-Free Rate in Theory

Michael Schmidt (a columnist for Investopedia) analyzed the risk-free rate ofreturn as one of the most basic elements of modern finance. Many of its mostfamous theories—the capital asset pricing model (CAPM), modern portfolio theory(MPT), and the Black-Scholes model—use the risk-free rate as the primarycomponent from which other valuations are derived. The risk-free asset appliesonly in theory, but its actual safety rarely comes into question until eventsfall far beyond the normal daily market volatility. Although it is easy to takeshots at theories that have a risk-free asset as their base, there are limitedoptions to use as a proxy. The risk-free rate is an important building block forMPT, which assumes there is one risk-free rate. The risk-free asset is the(hypothetical) asset that pays a "low" rate. The risk-free asset has zerovariance in returns and is also uncorrelated with any other asset. As a result,when it is combined with any other asset or portfolio of assets, the change inreturn is linearly related to the change in risk as the proportions in thecombination vary. MPT uses the risk-free rate as a starting point to determinethe "optimum" portfolio on the efficient frontier, the set of combinations ofassets' expected returns and volatility. The formula is used to calculate theexpected return that represents the capital allocation line, a measure of therisk of risky and risk-free assets, where the slope is known as the "reward-to-variabilityratio." The risk-free rate is an important attribution factorbecause it determines the slope of the line, which can determine the tangentportfolio (optimum portfolio) on the efficient frontier. MPT never assumed achange in the risk-free rate, simply because it was viewed as the prevailinglevel of interest rates on government bonds at a certain point in time. If therisk-free rate has changed in terms of risk characteristics, it would alsochallenge the slope of the capital asset allocation line and thereby theselection of the optimum portfolio. To prove this in a simple exercise, Figure1.1 shows two risk-free rates, "R(f)" at 0.25 percent and "R(f)" at 3 percent.R(f) represents the level of the risk-free rate where most central bank ratesare near zero, which has impacted money market rates and short-term governmentbonds trading at similar levels. R(f) is the new risk-free rate, at a higherlevel because a risk premium has been added to R(f). In Figure 1.1, this has animmediate result. The capital asset allocation line, "CAL (I)," shifts out to"CAL(II)," which changes the optimal portfolio (1) to portfolio (2) on theefficient frontier. The expected return of the optimal portfolio goes from 4 to6 percent, but what is notable as a result of a higher risk-free rate is thatthe annual volatility doubles from 5 to 10 percent. The risk premium of 2.75percent, the difference between R(f)* and R(f), consists of several components,such as inflation, default, and liquidity, but now also debt, deficit, andpolitical risk.

The term risk is often taken for granted and used very loosely, especially whenit comes to the risk-free rate. At its most basic level, risk is the probabilityof events or outcomes. Michael Schmidt shows that when applied to investments,risk can be broken down in a number of ways. There is "absolute risk" as definedby volatility, quantified by common measures such as standard deviation. Becauserisk-free assets "typically" mature in 3 months or less, the volatility measureis low and short term in nature. There is also the idea of "relative risk." Thisis risk when applied to investments and is usually represented by the relationof price fluctuations of an asset to an index or base. Lastly, there is "defaultrisk." In this case, it could be the risk the U.S. government would default onits debt obligations. Although the U.S. government has never defaulted on any ofits debt obligations, the risk of default has been raised during extremeeconomic events when the U.S. government has stepped in to provide a level ofsecurity that provided a perception of safety. Michael Schmidt argues that theU.S. government can spin the ultimate security of its debt in unlimited ways,but the reality is that the U.S. dollar is no longer backed by gold, so the onlytrue security for its debt is the government's ability to make the payments fromcurrent balances or tax revenues. This raises many questions about the realityof a risk-free asset. For example, say the economic environment is such thatthere is a large deficit being funded by debt and the current administrationplans to reduce taxes and provide tax incentives to both individuals andcompanies to spur economic growth. If this plan were used by a publicly heldcompany, how could the company justify its credit quality if the plan were tobasically decrease revenue and increase spending? That in itself has been therub up until the financial crisis: there was really no justification oralternative for the risk-free asset (source; Michael Schmidt).

There have been attempts to use other options, but the U.S. T-bill remains thebest option because it has been the closest investment—in theory and reality—toa short-term riskless security. This idea about the risk-free rate hasmaterially changed since the crisis. Until the crisis of 2008, the risk-freerate was rarely called into question. Reasons why this question is arising todayare that the economic environments in developed countries have remained indisarray or catastrophic events have occurred, such as credit market collapses,war, stock market collapses, and currency devaluations. These can all leadpeople to question the safety and security of a government as a credibleborrower. The best way to evaluate the riskless security would be to usestandard techniques, such as those to evaluate the creditworthiness of acompany. Unfortunately, such metrics applied to a government rarely hold upbecause a government basically exists in perpetuity by nature and has"unlimited" powers to raise funds in both the short and long term. A way thatthe risk-free rate is judged in markets for its level of valuation is byapplying the theory of the real rate of interest by Irving Fisher. In his workThe Theory of Interest (1930), he laid out a thesis that when the rate ofinflation is sufficiently low, the real rate of interest can be approximated bythe nominal rate minus the rate of inflation, which became known as the "Fisherequation." For inflation to stay low so that the Fisher equation holds, it isnecessary that inflation expectations remain stable. By replacing the inflationterm in the Fisher equation with inflation expectations, the real rate is basedon the nominal rate minus the expected rate of inflation. In other words, thenominal rate can be determined by taking the real rate plus the expected rate ofinflation. Why is this relevant for the discussion about the risk-free rate? Oneaspect that determines the nominal rate of a government bond is inflationexpectations. That means the yield also reflects an expectation of a future realrate in order to give the bondholder sufficient return for potential higherinflation down the road. This is called the "interest rate risk component" ofthe risk-free rate. When inflation rises, investors seek higher nominal interestrates that are above the rate of inflation. Coupled with expectations, thecentral bank may raise interest rates; higher inflation generally leads tohigher interest rates. Since 2009, inflation has been rising in most developedcountries from a combination of higher energy prices and large-scale assetpurchase programs by central banks that induced inflation expectations. Usingthe Fisher equation, the nominal risk-free rate could be approximated by the sumof the expected real rate and the expected rate of inflation. There is also a"credit component." This is the expectation of default and the ability tocontinue to borrow. In financial markets, this is distinguished by secured andunsecured borrowing and lending. "Unsecured" refers to higher credit riskbecause the collateral or promise backing the loan has a higher probability ofnot being fulfilled. An expression of how high that risk may be is the "swapspread." Interest rate swaps are derivatives contracts in which parties agree toexchange fixed and floating rates for a period of time. These contracts aretypically agreed upon between banks and private entities, but at times,government agencies that issue government bonds also use them for hedgingpurposes. The difference between the swap rate and government bond yield isoften seen as a sign of stress or calm in the financial system. To gauge theinterest rate risk and credit risk components in short-term interest rates,Figure 1.2 shows both measured in basis points (1/100th of a percent). Theinterest rate component is the difference between the actual short-term rate andshort-term inflation expectations. The other line is the swap spread, thedifference between short-term Treasury bond yield and interest rate swap. Whatis notable is that for the United States, both components have been on the risesince late 2008, when the Federal Reserve Funds rate has been at 0 to 0.25percent.

No Longer a True Risk-Free Rate

To state it in bold terms, there is no longer a "true" gauge for the risk-freerate. There are several reasons why. For example, Treasury bills have yieldedzero or negative returns over the past few years. Even though this may be a signof safety, as conceivably no or negative return implies no risk, in general,investors reject a negative or zero yield as being investable, either perguidelines or psychologically. As rating agencies downgraded a variety ofsovereign issuers, including the United States and the United Kingdom, theuniverse of AAA-rated government bond issuers has shrunk. The effect of this wasdramatic in smaller bond markets. For example, Sweden and Australia saw anincrease of foreign ownership of up to 80 percent, according to data of theSwedish and Australian Treasury. Such high ownership has served in crises timesas a potential catalyst for sudden capital withdrawal, affecting the value ofbonds adversely. Thus, even though the Australian and Swedish governments areAAA, their bond markets are vulnerable to capital withdrawal because foreigninvestors are likely more easily enticed to do so than domestic investors. Therewas a flight to quality during 2011 and 2012 stemming from the European debtcrisis. This led to large inflows into corporate bonds, specifically those inthe United States. The yield on the Barclays BBB-rated corporate bond index fellto a record low of 2.56 percent in 2012, below that of the yield on a 30-yearU.S. Treasury bond at some point. This is a reflection of investors' perceptionof safety, whereby corporations are seen as having a sounder, healthierfinancial state than the government. That said, a corporate bond is bydefinition never defined as "risk free" because it is generally lower rated thana government bond, and companies are always vulnerable to the economy,competition, and access to capital markets. As interest rates fell to new lows,the duration of 30-year government bonds has risen to over 20 years, producingmore risks—interest rate, credit, and inflation—for fewer yields. To the samedegree, thanks to quantitative easing, U.S. mortgage-backed securities by FannieMae and Freddie Mac became excessively overvalued relative to their prepaymentrisk. These examples show that even though interest rates are at record lows andthus perceived to be in demand, there is a mismatch with the underlyingfundamental risk. In a different way, the European debt crisis revealed whatmodern-day sovereign risk is about. European government bond yields becamedistressed because of a combination of heightened political, economic, andfinancial risk. Underneath there was a host of risk elements, includingsequential rating downgrades, private sector involvement, restructuring,currency convertibility, social-political rejection, and "debt mutualization."These elements are no longer unique to European government bonds, but now extendto all major sovereign bond markets for the simple reason that there is too muchgovernment debt outstanding and too little growth to back those liabilities.

Another form of a risk-free rate was the London Interbank Offered Rate, "LIBOR."During the heyday of the structured credit securitization boom of 2002 to 2007,this was regarded as the trusted rate to back approximately $300 trillionnotional in derivatives, according to the Bank for International Settlements.LIBOR was a rate that was fixed by a panel of banks each day at 11 AM Londontime. It also served as a benchmark for interbank lending. By 2006 to 2007,there was a growing suspicion that a number of banks were under- or overstatingLIBOR as confidence started to wane in the valuation of mortgage-backedsecurities and structured credit often referenced to LIBOR. After initialinvestigations, LIBOR became a "scandal" in 2012, when even the Bank of Englandmonetary policy committee members were questioned in terms of their involvementand oversight. The confidence in LIBOR became so undermined that it resulted ina regulatory overhaul. The result was that LIBOR embedded in floating ratemortgages, credit derivatives, and short-term interest rate futures, was nolonger regarded as a "risk-free rate." It questioned the valuation of manyderivatives.

(Continues...)

Excerpted from The End of the Risk-Free by BEN EMONS. Copyright © 2014 McGraw-Hill Education. Excerpted by permission of McGraw-Hill Education.
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Details zur Ausgabe

• Verlag: McGraw Hill
• Erscheinungsdatum: 2013
• Sprache: Englisch
• ISBN 10: 0071819525
• ISBN 13: 9780071819527
• Einband: Tapa dura
• Anzahl der Seiten: 254
• Kontakt zum Hersteller: Nicht verfügbar
• Verantwortliche Person: Nicht verfügbar