Aug 28

What is the Risk Free asset?

This question is probably only important when establishing a base-line return expectation before we accept various type of investment risk.

I guess we all know that technically there is no such thing as a Risk Free Asset but generally speaking it is widely believed that Cash is the risk free asset. Whilst I’m prepared to accept that when the investment timeframe is unknown, Cash is probably quite a reasonable proxy for the Risk Free Asset.

BUT, when we know the investment timeframe then cash is far from a risk free asset as throughout that timeframe interest rates may drop resulting in a lower than hoped return or perhaps inflation can rise faster than the cash rate resulting in a negative real return…hence both of these examples show why cash can be far from risk-free.

If we do know the timeframe then we can adjust our risk–free return expectations one of two ways.

The first way is to simply choose the Government Bond yield over that timeframe. For example, if an investors timeframe is 5 years the current yield for a 5 year government bond is around 3%…so for the 5 year investor the risk-free rate is 3%. that is because if we hold the bond for 5 years we are guaranteed a 3% return and no less. Some could argue that a 5 year bank deposit is also risk-free because it is backed by the government but between now and the next 5 years, the government could always change its mind so it a little riskier than risk-free…but its not bad.

The second way is using government inflation linked bonds over the specific timeframe. In my mind Government Inflation Linked bonds are truly the closest to a risk-free investment because not only do you receive a guaranteed income from the government over a specific timeframe, but the value of your spending dollar is not diminished by higher inflation…unlike our cash example above. In Australia, the shortest inflation linked bond has a term to maturity of around 7 years and it is offering a real return of a little over 1.3% at the time of writing. That compares to a 7 year nominal bond paying around 3.15%pa so inflation only has to be roughly more than 1.85%pa over the next 5 years to break even and if inflation is higher than it works out to be a better deal. From a retiree’s perspective, inflation can be quite damaging to a portfolio so safely hedging this risk with a guaranteed return is quite attractive.

As you would expect, inflation linked bonds do have significantly longer maturities and are less frequently issued than traditional bonds but if you want low risk, and want to hedge inflation over a long timeframe, then inflation linked government bonds are the closest thing to risk free and are the forgotten benchmark of long term investing.

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