The bond/gilt market

Linton

The risk-free rate (RFR) is very useful as a benchmark.  If you see an investment marketted as low risk returning more than the RFR then you can be pretty sure that it is not low risk.  Similarly if you are thinking of an investment with a likely return much lower than the RFR perhaps you should reconsider.

zagfles

Linton said:

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

The main risk someone investing in TRY-denominated debt should fear is what the TRY will be worth when it is repaid. I would call that currency risk. I am applying the 'currency risk' label to both UK and Turkish investors in Turkish bonds, as I agree with you that it makes no sense to call it different things to different investors depending on where they live.

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

It doesn't seem right to call it inflation risk when it is particular to foreign exchange movements and may or may not result in the money going less far depending on the spending needs of the recipient.

The massively predominant risk to a Turkish investor investing in Turkish govt gilts is inflation, even if he/she only ever buys wholly domestically produced products and services. It's not exchange rate movements (which are mainly an effect of inflation anyway, not a cause).
The exact same risk a UK investor in UK gilts faces, except for scale. UK inflation is likely to be far lower than Turkish.

Whether it should be called inflation or currency risk depends on how you are framing it, so let's not get drawn into another semantics discussion, because all that matters is that there is a risk premium due to a higher perceived risk, which sets it above the risk level of other lower risk assets considered close or at the "risk free rate" as it is commonly labelled. </Humphrey Appleby>

It's the whole point about the term "risk free rate", and why I think it's misleading. It's easy to see in high inflation environments like Turkey where inflation risk is far higher, but the same risk (different scale) applies to the UK and other countries. Nowhere is "free "of that risk.

Investing, however you do it, cannot be free of risk unless you find some one else with the ability to take on the risk for you eg with an index linked bond or annuity.

Of course. Hence my problem with the term "risk free" for flat gilts. However universally accepted it is.

zagfles

masonic said:

zagfles said:

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

No disagreement there, but the amount of risk will be proportional to the instability of the currency.

Well then - exactly my point. UK and Turkish flat gilts are not "risk free", they both have risk but on different scales. You want to call that risk "currency risk" rather than "inflation risk", fine, but at least you now seem to agree neither are really "risk free", however widely (mis)used the term is.

zagfles

Linton said:

The risk-free rate (RFR) is very useful as a benchmark.  If you see an investment marketted as low risk returning more than the RFR then you can be pretty sure that it is not low risk.  Similarly if you are thinking of an investment with a likely return much lower than the RFR perhaps you should reconsider.

I can understand its usefulness as a benchmark, but the term IMO is misleading.

masonic

zagfles said:

masonic said:

zagfles said:

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

No disagreement there, but the amount of risk will be proportional to the instability of the currency.

Well then - exactly my point. UK and Turkish flat gilts are not "risk free", they both have risk but on different scales. You want to call that risk "currency risk" rather than "inflation risk", fine, but at least you now seem to agree neither are really "risk free", however widely (mis)used the term is.

For the record, I have never suggested any investment is entirely free of risk, or suggested any real world investment should be labelled "risk free". In my first contribution to the thread, I posted a link defining "risk free rate" as a theoretical rate of return. It seems to me that in our exchanges you must have been conflating my use of "risk free rate" with "risk free investment". You can have the former in an investment with some risk, whereas you cannot have the latter in any investment.

zagfles

masonic said:

zagfles said:

masonic said:

zagfles said:

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

No disagreement there, but the amount of risk will be proportional to the instability of the currency.

Well then - exactly my point. UK and Turkish flat gilts are not "risk free", they both have risk but on different scales. You want to call that risk "currency risk" rather than "inflation risk", fine, but at least you now seem to agree neither are really "risk free", however widely (mis)used the term is.

For the record, I have never suggested any investment is entirely free of risk, or suggested any real world investment should be labelled "risk free". In my first contribution to the thread, I posted a link defining "risk free rate" as a theoretical rate of return. It seems to me that in our exchanges you must have been conflating my use of "risk free rate" with "risk free investment". You can have the former in an investment with some risk, whereas you cannot have the latter in any investment.

I didn't think you had. This all started with this post quoted below where you imply Turkish bonds specifically "should probably not" be considered risk free. If you'd have said all govt (flat) bonds I'd have agreed.

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available. The key point is that the risk free rate of return doesn't need to be positive in real terms (in theory it doesn't need to be positive in nominal terms either). It certainly hasn't been positive in real terms recently. The "real" risk free rate is something different, see https://www.investopedia.com/terms/r/risk-freerate.asp

And it is just semantics. A consensus was formed about the meaning of the term within that field, and that is what the term is taken to mean by reasonable people discussing investments.

masonic

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

No disagreement there, but the amount of risk will be proportional to the instability of the currency.

Well then - exactly my point. UK and Turkish flat gilts are not "risk free", they both have risk but on different scales. You want to call that risk "currency risk" rather than "inflation risk", fine, but at least you now seem to agree neither are really "risk free", however widely (mis)used the term is.

For the record, I have never suggested any investment is entirely free of risk, or suggested any real world investment should be labelled "risk free". In my first contribution to the thread, I posted a link defining "risk free rate" as a theoretical rate of return. It seems to me that in our exchanges you must have been conflating my use of "risk free rate" with "risk free investment". You can have the former in an investment with some risk, whereas you cannot have the latter in any investment.

I didn't think you had. This all started with this post quoted below where you imply Turkish bonds specifically "should probably not" be considered risk free. If you'd have said all govt (flat) bonds I'd have agreed.

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available. The key point is that the risk free rate of return doesn't need to be positive in real terms (in theory it doesn't need to be positive in nominal terms either). It certainly hasn't been positive in real terms recently. The "real" risk free rate is something different, see https://www.investopedia.com/terms/r/risk-freerate.asp

And it is just semantics. A consensus was formed about the meaning of the term within that field, and that is what the term is taken to mean by reasonable people discussing investments.

Fair enough, I was responding to your extrapolation of Johnjdc's erroneous definition of risk free rate, namely that Turkish bonds gave a "risk free" 27% pa return, which is clearly absurd. It is obvious that there is a large degree of risk to anyone comparing the coupon with that of the lowest risk (not risk free!) bonds available. Also that the risk free return can be negative in real terms (I didn't spell it out, but this itself a risk). I certainly did not intend for anyone to infer anything more than that.

Linton

zagfles said:

Linton said:7

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

The main risk someone investing in TRY-denominated debt should fear is what the TRY will be worth when it is repaid. I would call that currency risk. I am applying the 'currency risk' label to both UK and Turkish investors in Turkish bonds, as I agree with you that it makes no sense to call it different things to different investors depending on where they live.

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

It doesn't seem right to call it inflation risk when it is particular to foreign exchange movements and may or may not result in the money going less far depending on the spending needs of the recipient.

The massively predominant risk to a Turkish investor investing in Turkish govt gilts is inflation, even if he/she only ever buys wholly domestically produced products and services. It's not exchange rate movements (which are mainly an effect of inflation anyway, not a cause).
The exact same risk a UK investor in UK gilts faces, except for scale. UK inflation is likely to be far lower than Turkish.

Whether it should be called inflation or currency risk depends on how you are framing it, so let's not get drawn into another semantics discussion, because all that matters is that there is a risk premium due to a higher perceived risk, which sets it above the risk level of other lower risk assets considered close or at the "risk free rate" as it is commonly labelled. </Humphrey Appleby>

It's the whole point about the term "risk free rate", and why I think it's misleading. It's easy to see in high inflation environments like Turkey where inflation risk is far higher, but the same risk (different scale) applies to the UK and other countries. Nowhere is "free "of that risk.

Investing, however you do it, cannot be free of risk unless you find some one else with the ability to take on the risk for you eg with an index linked bond or annuity.

Of course. Hence my problem with the term "risk free" for flat gilts. However universally accepted it is.

Whereas I use the term risk free to refer to investments that will always  provide the high-level outcome for which they are intended despite unpredictable external events barring end of the world as we know it scenarios.

That is a different matter to problems arising when investors use inappropriate investments to meet their objectives.

MK62

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

masonic

MK62 said:

The problem with trying to include inflation in the "risk free rate" is that you have no idea what inflation will be.
At the typical individual investor level, I'm not sure it matters either tbh.
If you consider someone with say £10k sitting in a current account or in a safe at home, then to him/her, the risk free rate is going to be the return rate obtainable over the timeframe in question, with no risk to capital (barring armageddon events, as Linton suggests). For short timeframes, that's probably going to be bank/BS deposit accounts........for longer timeframes, gilts are really the only option.......but in any case the inflation risk is the same, and hence cancels out.
The "real" return that investor will get is unknowable........and the longer the timeframe, the more unknowable it becomes. Fair enough though, just because, it cancels out between the two options, doesn't mean it goes away.......inflation risk remains, it's just not quantifiable (not without guessing anyway).
Perhaps it should be called "nominal risk free rate", to make it more apparent that it doesn't account for inflation......

Complicated by the fact that index linked investments exist, so whether or not you know what inflation will be, you can buy an investment with a known real rate of return. You can look at the difference between comparable nominal and inflation linked investments to determine the market's implied future inflation rate, but if you invest what you will get is the actual inflation rate as determined by the index used. So you don't need to know the inflation rate to protect your capital from inflation risk, providing you trust the inflation index.

I agree with zagfles insofar as "risk free rate" should not be used to attach an unqualified "risk free" label to an investment. The risk free rate is simply a floor for the nominal rate of return all investments must pay to entice a rational investor to take risk with their capital. It is the convention for all investment returns to be assumed nominal unless stated otherwise, and the risk free rate is no different, having a real risk free rate counterpart. Only the lowest risk investments are able to entice money in at around the risk free rate, and in an efficient market the riskier the investment the higher premium it must pay above the risk free rate to entice investors to invest.

Whether you need a nominal or inflation protected investment depends on the nature of your liabilities. If you are holding capital to later discharge a nominal debt or make a fixed price purchase, then your situation is different to someone who is holding capital to fund their living costs in the future. An index linked investment would be ever so slightly higher risk in the former situation due to the possibility of deflation, but lower risk in the latter situation because it would be more aligned with prices whatever happened to the spending power of the money. 

With the benefit of context, one can truly describe a scenario as risk free, such as where one puts money into a savings account from their self-employment earnings to cover the cost of their tax bill. Or risky, such as someone in their 20s using a cash ISA to save for retirement.