Investing: The new risk-free rate?

A LOT hangs on the concept of the “risk-free rate”. In financial theory, it is the market off which other assets are priced; companies pay an extra spread over the risk-free rate, equities offer a “risk premium” in the form of a higher long-term return to compensate for their higher short-term volatility.

In most markets, it is the local government bond that constitutes the risk-free rate. Governments have the power to raise taxes to meet their bills; these days, they also have friendly central banks that will create money to buy their bonds. Over the long sweep of history, of course, many governments have defaulted, particularly to foreign creditors. And events over the last five years have reminded investors that risk is very much a factor; Greece has defaulted on part of its debts.

In global terms, Treasury bonds are traditionally seen as the risk-free market; they are certainly the most liquid. At moments of market nervousness in recent years, investors have flocked into Treasury bonds and yields have fallen, even when (as in 2011 when there was a crisis over the rising of the debt ceiling and the country’s credit rating was downgraded) the US has been the cause of the nervousness.

But perhaps sentiment is changing. As the graph shows, the gap between the yield on German 10-year bunds and those on the equivalent Treasury bonds is widening. This is not a unique situation; the gap was wider in the late 1980s. But Germany meets the definition of a safe haven; it has low inflation, a budget surplus and a current account surplus. America’s economy may have improved, but it still has current account and budget deficits, and it has what is seen as a dysfunctional political system in which the parties constantly bicker, whereas Angela Merkel heads a broadly-based national coalition. If in doubt, buy German.

11 March 2014 | 4:41 pm – Source:

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