Podcast Summary
The assumption of government bonds as risk-free investments is being challenged: The shrinking number of triple A-rated sovereigns and the potential downgrade of US debt could change the perception of risk-free investments, with implications for the bond market and global economy.
The assumption of government bonds as risk-free investments may no longer hold true due to rising national debts and dwindling credit ratings. Aswath Damodaran, a finance professor and valuation expert, raised this question in a recent tweet thread, pointing to the potential downgrade of the US debt and its impact on the bond market. Despite the US Treasury market still being considered the safest debt market, the number of triple A-rated sovereigns is shrinking, and the reliability of the triple A credit rating is being questioned. The episode discusses the implications of this shift, including the 2011 downgrade of US bonds and its unexpected market reaction. The hosts also explore some surprising triple A-rated countries, such as Australia and Canada, and the potential consequences of a world with fewer perceived risk-free investments.
Germany's past lessons and credit ratings: Germany's past experiences and credit agencies' ratings keep it from adopting risky fiscal policies, while the US's low credit spread and risk-free rate reflect its relatively stable economic situation
Germany is unlikely to adopt reckless fiscal policies due to past lessons learned, and credit rating agencies' triple A ratings come with an unofficial time element. The credit spread on bonds, like the US, serves as a real-time market indicator of a country's potential default risk, with the US currently having a very low spread. The risk-free rate, which is the rate of return on an entity with no credit or reinvestment risk, is closely associated with government bonds. The US government bond is considered almost risk-free but not entirely, and reinvestment risk refers to the assumption that the interest earned can be reinvested at the same rate.
Understanding the complexities of the risk-free rate: The risk-free rate, used to price assets, is not straightforward. It's important to consider reinvestment risk and choose an investment with zero coupons and maturity matching the investment horizon for true risk-freeness.
The risk-free rate, which is crucial in finance, is not as simple as it seems. It's essential to consider reinvestment risk when determining the risk-free rate, as the returns from reinvested coupons may differ from the yield. Additionally, for a risk-free investment to be completely free of risk, it should have zero coupons, and its maturity should match the investment horizon. The risk-free rate is crucial because it allows us to price any asset with future cash flows by discounting them using the risk-free rate. The difference between the asset's expected return and the risk-free rate represents the risk premium the investor demands for taking on the asset's specific risks. In summary, understanding the concept of the risk-free rate and its implications is vital for making informed investment decisions.
Understanding the impact of a low risk premium on potential investment returns: A lower risk premium increases the likelihood of lower investment returns, but it doesn't guarantee it. Other risks like credit, liquidity, duration, and political risks can significantly impact returns and should be factored into investment decisions.
The risk premium, or the additional return investors expect for taking on risk, is currently lower than it has been for a long time. This means potential returns on investments may be lower than expected. However, it's important to remember that a low risk premium doesn't guarantee lower returns, but it does increase the likelihood. When considering investments, it's essential to be aware of other risks beyond the risk-free rate, such as credit risk, liquidity risk, duration risk, and political risk. These risks can significantly impact returns and should be factored into investment decisions. Understanding the risk-free rate and the compensation for various risks is crucial for making informed investment choices. Despite the common belief that government bonds are risk-free, history shows that even developed market governments have defaulted on their debt. It's essential to consider these risks and the potential impact on returns when making investment decisions.
Impact of risk-free rate on investment decisions: The risk-free rate influences investment decisions by setting the minimum expected return for companies and investors. Factors like monetary policy, arbitrage pricing, and economic growth impact the risk-free rate, which can lead to changes in investment behavior.
The risk-free rate plays a crucial role in investment decisions and is influenced by various factors such as monetary policy, arbitrage pricing, and economic growth. Companies invest in projects only if the expected return is above the hurdle rate, which includes the risk-free rate. If the risk-free rate increases due to monetary policy, companies may be less likely to invest and instead opt for risk-free assets like government bonds. Arbitrage pricing suggests that a hedged investment should return the risk-free rate. The risk-free rate is not determined solely by government bonds but is a theoretical construct that underpins all investments. In Europe, the risk-free rate is often discussed in relation to government bonds of specific countries, with the spread between the yields of these bonds and German bonds indicating the country's default risk. The long end of the curve, representing long-term government bond yields, is driven by inflation and real growth expectations in a country. Central banks are more in discovery mode and follow the market in setting interest rates, which in turn influence the risk-free rate.
Central banks' roles extend beyond setting interest rates: Central banks indirectly influence economic activity via inflation expectations and risk-free rates. The neutral rate allows the economy to function, while an inverted yield curve doesn't always mean a recession, and government bonds may not always reflect the risk-free rate.
The role of central banks in the economy goes beyond just setting interest rates. They can influence economic activity indirectly by impacting inflation expectations and the risk-free rate. The neutral rate of interest is where the central bank isn't causing a headwind or a tailwind, allowing the economy to do its thing. Central banks can also impact the yield curve, and an inverted yield curve doesn't necessarily mean a recession is imminent, but rather that the central bank's actions may have influenced the curve. Additionally, government bonds are not always a reliable proxy for the risk-free rate, especially in emerging markets. Sovereign defaults for developed markets are a political decision rather than an inevitable outcome, but political instability and dysfunction can increase the risk of a default.
Potential unsustainability of US government debt: Fiscal deficits and demographic challenges could increase interest rates and interest payments on US debt, potentially impacting the demand for US government bonds and increasing the value of established company stocks.
While the US government's ability to repay its debt through money printing is currently credible, the increasing fiscal deficits and longer-term demographic challenges could make the debt unsustainable in the future. This could lead to higher interest rates and increased interest payments on the debt, making it more difficult for the government to service its debt. If investors begin to question the default risk of US government bonds, the demand for safe assets like stocks of established companies could increase, leading to higher valuations for these stocks. However, it's important to note that this is a potential future scenario and not a certainty. The current situation remains stable, but it's essential to keep an eye on fiscal policies and demographic trends.
Safe assets in times of crisis: Safe assets like government bonds and cash provide stability during market turmoil, but their scarcity can lead to higher premiums. Understanding governance and political decisions is crucial in maintaining their perceived safety.
The concept of safe assets and their role in the financial market is crucial during times of crisis. The scarcity of safe assets can lead to a higher premium for them, but the absence of safe assets altogether would result in unpredictable market corrections and a significant shift in risk perception. Bonds, particularly government bonds from developed markets, are expected to remain as safer options even if they carry some risk. However, the perception of safety can change rapidly, and people might be more willing to take risks if there's nothing safe left. Cash, which is essentially a zero-duration bond, can be considered a safe asset, but holding it means expecting interest rates to rise further. The discussion also touched upon the importance of understanding the role of governance and the potential impact of political decisions on the financial market.
Investing in bonds: Should you stick to the short end?: With an inverted yield curve and negative term premium, traditional 60/40 portfolios may cause pain for long-term bond holders. Short-term bonds and market timing offer potential buffers and returns, but investor's risk tolerance and long-term goals should guide the decision between cash and bonds.
The traditional 60/40 portfolio, which includes holding intermediate or long duration government bonds for the 40% fixed income portion, is typically done to earn a term premium for taking duration risk. However, with the current inverted yield curve and negative term premium, investors are actually punished for taking this risk. Yet, historical data shows that bonds still offer a higher return than cash. This is because when stocks crash, bonds might rally, providing a buffer for the portfolio. Currently, yields at the long end of the curve may increase, causing pain for long-term bond holders. Therefore, if you're investing in bonds, it might be wise to stick to the short end of the curve until inflation is under control. Market timing with bonds is also possible due to their predictable returns. Despite the recent interest in bonds, the 60/40 portfolio's bond component is usually managed through a bond fund with a constant duration, meaning investors take on the duration risk and accept the hit if yields increase. The choice between cash and bonds ultimately comes down to the investor's risk tolerance and long-term return expectations.
Cash vs Bonds: Similar Volatility, Different Perks: During inflation, cash outperforms bonds, making it a valuable asset for stability in a portfolio.
The performance of cash and bonds in a portfolio may not be significantly different in terms of volatility. The speaker mentioned an 11% volatility for cash and 11.2% for the portfolio with bonds, and the graphs showed a close tracking of the two. However, during periods of high inflation, cash tends to outperform bonds. This is why some investment strategies, like the all weather portfolio, have high cash allocations. It's ironic that Ray Dalio, who once called cash "trash," has since acknowledged its value. The key message is that cash is a valuable asset that can provide stability during inflationary periods. As the speaker said, "cash doesn't crash." This podcast is for informational and entertainment purposes only, and listeners are encouraged to seek independent financial advice before making any investment decisions.
