by elmads

Introduction

Investing has been getting more traction now than before. This is also partly thanks to the internet and social media, where information travels faster and is easier to acquire.

People are starting to turn their attention on the concept of investing—employing their own money to make money for themselves.

It broadened some people’s view of how money works and gave them additional knowledge on top of the traditional way of making money, which is spending one’s precious time and effort in exchange for money.

With excitement, some individuals immediately jump into the world of investing, but as with most beginners, they find themselves lost in this gigantic world. A few people invested all their hard-earned money without knowing what they were doing, hoping that their faith would make them multi-millionaires, and indeed faith can play. Such stories of losing everything in a blink of an eye are common to jackpot seekers. And there are a lot who see it as a gambling den, though not all, as there are others who dip their toes first in the volatile waters of the investment world.

Everyone started as a beginner, and every investor, from the professionals to the retail passive investors, had their own beginner’s luck, and the truth can be said as well for its reverse, the disastrous and embarrassing experiences in the market. Both sides of the coin will always play their hands.

That said, I would say it is easier now to learn from the experiences of other investors, their wins and losses, and use them as a guiding light for our investment journey.

This is the reason you’re reading this: you are looking for information that you might find useful for yourself and your investment journey. I am the same as you; despite doing blogs regarding investing for years now, I still find myself not knowing things in this vast world. I still have a lot to learn, which I am always and will forever be willing to share with everyone.

Let’s continue to learn and improve together.

Cheers to a better financial life!

The US Government Bond

📝 Before I start, I just want to disclose this information. All of what I’ll be writing in this blog is based on what I’ve learned from Professor Aswath Damodaran’s Valuation Class. The majority of what I practice in valuation—finding the value of assets—is derived from his teachings. With that aside, let’s now talk about risk-free assets and the risk-free rate.

One of the most frequently asked questions regarding investing is “Where can I invest my money?”. It’s one of the hardest questions you can throw at someone in the investing world. It’s like asking the question, “How do I become successful in life?”

These questions are so broad, complex, and multifaceted that no one specific answer is applicable to each and every one of us. We must consider a lot of things just to answer, “Where can I invest my money?”, like your current financial circumstances, your responsibilities, and whether you have debt. How much are you earning per month or per year? What are your financial goals? What’s your risk tolerance? What is your relationship with money? Do you have a deep understanding of yourself? And there are loads more to tackle.

Just as success can mean different things to different people, investment choices depend on factors like financial goals, time horizon, and risk appetite. Both questions also highlight the importance of thorough research, seeking expert advice, and continuously learning to make informed decisions.

Just as there’s no one-size-fits-all answer to achieving success, the same holds true for finding the right investment avenues.

Despite such an explanation, there are some people who would still insist on an answer right there and then. If they have a basic grasp of some of the concepts in equity investments, I usually answer index equity funds and explain the risks involved in them, like the rapid changes in their market price, but if a person is a complete novice, I usually tell him/her to invest in US Treasury bonds, commonly known as US government bonds, and hold them to maturity (the maturity of choice is dependent on an individual’s financial goals). This is only if these people insist on me giving them an immediate answer on where to invest their money, despite their refusal to share details about their financial goals, financial circumstances, and views about money.

I know I shouldn’t be answering the question from such individuals who don’t want to share important information for me to be able to deduce an almost accurate answer for them, but hey, I always tell them at the end of our conversation to not follow my opinion about it because I’m just a student in this financial and investment world, and if they blindly follow my own financial investment principles and ideology without doing their own due diligence, then financial pain and suffering will eventually be knocking on their door.

Going back to the index fund and US government bonds Some people are surprised to hear about bonds. Only a few know about it, while others who understand it will question my view. They would say, You might as well just put your money in a high-yielding bank savings account than in US government bonds. What others do not understand from my US government bond choice is that this is, in theory, the almost only RISK-FREE ASSET in the world.

What is a Risk-Free Asset?

What is a Risk-Free Asset?

Risk-free, as the name implies, has 0% risk.

All investments have risks; don’t believe those people who will say that this asset or financial vehicle is risk-free. Stocks, bonds, real estate, commodities, cryptocurrency, and even cash itself have their own risks. Also, add the bank savings accounts. Do you think your money in the bank is risk-free? Fraud and bankruptcy, anyone?

📣  https://elmads.com/?p=1261 – Investment Risks 

You see, when investing, people tend to look for an asset that will give them the most return on their initial investment, which is understandable. We invest to make money, so that thought is completely sensible, yet there are always two sides to the coin. An upside has always had an opposite, which is the downside, and in investing, the downside is part of the risk.

People always forget to manage risk, as they only look at the possible gains, not the possible losses. Investing taught me the simple idea of being realistic, and that’s through risk management.

“Risk is not something to be avoided at all costs; rather, it’s something we need to understand, analyse, and work with.”

—Professor Aswath Damodaran

So, we must remember that ALL assets have risk and that we need to learn to manage risk. That’s a good start.

When we invest in risky assets, we then need to be cautious about their possible downsides. Therefore, in the financial world, investors put a risk premium on all risky assets.

What’s a risk premium you asked? It is the rate that we put on top of a riskless asset. So, all assets have a risk premium. Why? Well, because all the returns of any asset are not guaranteed.

Dividends, coupons, rental income, Price appreciation of assets: how much would you be receiving in the future for these? What would be the market price after 6 months on a specific asset? Are you sure that you’ll be receiving something from these assets? In short, all of the returns we’ll be receiving from a risky asset are not 100% certain and can only be projected in the future.

The COVID-19 pandemic happened in 2020; some companies stopped giving dividends, rental incomes were not paid, and debt obligations were not fulfilled. In short, the returns are not guaranteed, as there is always a chance of default.

This is the reason that risk premiums are put on top of these assets because they don’t give guaranteed returns, unlike a RISK-FREE ASSET. At the same time, when taking risky assets, it is only normal for investors to look for higher returns compared to a risk-free asset, as they would be taking more risk. 

Evan, you keep on saying “Risk-Free Asset”, which in the previous section you said that is the government Bond, but then you also stated that bonds have risks. You’re confusing me.

I apologise for that, but hear me out: the bond asset class is indeed a risky asset except for one, and that’s the US Treasury, commonly known as the US government bond.

Let me explain why.

The Risk-Free Rate

A risk-free asset is defined as an asset that gives GUARANTEED returns. The actual return is always equal to the expected return.

In addition, the risk-free rate is the guaranteed return you’ll get from the risk-free asset.

For instance, a 10-year US government bond will give your initial investment 4% per year in income.

In our example above, the expected return is the $500 yearly coupon payment, while the actual return should also be the $500 yearly coupon payment.

In this case, if the US Treasury is considered a risk-free asset, then the 4% coupon rate (Coupon payment divided by Par Value = Coupon Rate or $500 / $12,500 = 0.04 (4%)) is the risk-free rate.

Again, this is because the $500 yearly coupon is a guaranteed return thus its coupon rate, which is 4% is the risk free rate.

The question is, why is the US government bond considered a risk-less asset?

To consider an asset a riskless asset, as per Professor Aswath Damodran, it must meet two basic conditions.

• There can be no default risk.
• There can be no reinvestment risk.

There Can Be No Default Risk

A default risk is the probability that a borrower will not make the required payments on a debt obligation.

• Corporations have default risk—the chances that they won’t be able to pay their debts.
• Real estate has default risk via mortgages.
• Commodities, too, have default risk in the form of trade credit to finance the acquisition of a commodity.

Anything that has debt attached to it has a default risk.

In theory, the US government doesn’t have default risks, not because their government is better run than corporations, but because they usually control the printing of currency and can continue to borrow large amounts of money.

If a 10-year US government bond states that it would give $500 annually, as it has no default risk, you would then receive a guaranteed $500 per year until its maturity date.

If ever the US government encounters a financial problem or a risk of default, they could always increase their debt ceiling.

“The US debt ceiling is the maximum amount that the U.S. government can borrow by issuing bonds. If the Treasury Department can’t pay expenses when the debt ceiling is reached, there is a risk that the U.S. will default on its debt.”

—Investopedia.

To answer this problem, the US just keeps on pushing the debt ceiling higher. They’ve just done this a lot of times in the past, most recently in June 2023.

“Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit—49 times under Republican presidents and 29 times under Democratic presidents.”

—U.S. Department of Treasury (https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit#:~:text=Congress%20has%20always%20acted%20when,29%20times%20under%20Democratic%20presidents.)

With the debt ceiling pushed higher, the US government can continue to borrow money through US government bond offerings, which is to raise capital and pay their financial obligations.

When printing money, the federal reserve (US Central Bank) doesn’t print money with the sole purpose of paying off the government’s debt but to control the prices of goods and services, inflation, and the economy.

On top of that, the USD is the world’s currency. Demand for it is high both domestically and internationally, as it is used in global trade. It is highly liquid, and the US economy is known as the most stable economy today.

And what happens to the USD will significantly impact the global economy.

There are a lot of strings connected to these complex financial worlds, but generally speaking, US government bonds are considered a “risk-free asset” because they are backed by the US economy, its government, and the USD.

Just a word of caution. The US government bond is considered a riskless asset, but that doesn’t mean that it is the best asset class. There are a lot of risks involved in investing in bonds; one example is that their market price is highly sensitive to the federal funds rate (US Central Bank rate). I’ve discussed this in my Bonds Asset Class blog.

There Can Be No Reinvestment Risk

In valuing assets, we usually use discounted cash flow.

It is done by projecting the future cash flows of an asset over its lifetime and discounting them today (present value) using a discount rate that is based on the possible risks the asset possesses.

Usually, investors project the cash flow of an asset for 5, 10, and 20 years in the future. The further in the future an investor makes the forecast, the higher the chances that it will be inaccurate. This is the reason why a 10-year or less is the preferred time horizon for a DCF analysis.

But then, if you stop projecting in year 10, how about in years 11, 12, 13, and so on and so forth?

Let me ask you a question: when you invest in a company, how long do you think the company will stay operational? Let’s use Nike. How long do you think the company will survive? It can be 10 years from now, 20 years from now, or even forever. The point is that no one knows for certain.

“To value a company, you have to estimate the cash flows forever. This sounds like my vision of hell, where an Excel spreadsheet never ends”.

—Professor Aswath Damodaran

So, one of the answers to an infinite possibility in the future regarding cash flow is to find a terminal rate.

“This is the famous terminal value equation you’ll see at the end of every valuation. It is basically the present value of all cash flows beyond years 5 or 10 with that equation, but for that to work, your cashflows have to grow at a constant rate forever.”

—Professor Aswath Damodaran

A terminal growth rate is usually in line with the long-term rate of inflation but not higher than the historical gross domestic product (GDP) growth rate. Some investors usually use the risk-free rate as the terminal rate.

That is the full circle of why a risk-free rate is integral to doing an asset DCF valuation.

We now go back to the fact that there is no reinvestment risk to consider an asset risk-free.

If an investor, let’s say, is doing a 10-year projection of company XYZ’s future cash flow using a 6-month Treasury bill rate, while default-free, it is not risk-free. This is because after six months we wouldn’t know what the Treasury bill rate would be anymore, and that means that there is a reinvestment risk of a different rate after six months.

This is the reason why a duration matching strategy is advised, where the duration of the default-free security is used as the risk-free rate to match up with the duration of the cash flows in the analysis.

In summary, if an investor does a 10-year DCF analysis, then he or she should use a 10-year duration of a risk-free rate for a risk-free asset. A 5-year DCF analysis, then a 5-year duration of a risk-free rate of a risk-free asset, and so on and so forth

To Sum It Up

• To consider an asset completely risk-free, it should have a zero-default risk. meaning the return on the asset is guaranteed regardless of the economic condition.
• All assets have risk, but in theory, the US government bond is risk-free.
• The US government doesn’t have default risks, not because their government is better run than corporations, but because they usually control the printing of currency and can continue to borrow large amounts of money.
• There is an assumption when doing discounted cash flow that companies live forever, as no one can accurately project a company’s lifetime. This is the reason why investors estimate the cash flows of a specific company into perpetuity by using a terminal value rate, which is usually based on the risk-free rate of a risk-free asset.
• One of the important roles of a risk-free asset is to use its current risk-free rate as a basis for the terminal value rate in a discounted cash flow valuation analysis. It’s sensible to use this as this puts conservatism in line with the eternal growth of cash flows.
  
  As we don’t know what the future holds and we don’t know for how long an asset will be able to continue to generate cash flows for us, using the risk-free rate is a no-brainer for terminal value rates. 
  
  Nonetheless, this isn’t set in stone, as other investment analysts may use different rates depending on their own understanding of the asset and their own assumptions.

Knowledge is my sword and patience is my shield.

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.