Risk-free rate

When you decide to invest in equities, or property, or bonds, or anything else, the return you expect to get should reflect the amount of risk you are taking. In theory (though not always in practise), the more risk you shoulder, the bigger the return you should expect. One way to think about the size of return you should be aiming for is to consider the return you could get if you took absolutely no risk at all – the “risk-free rate of return”.

Clearly, there is no such thing as a 100% risk free asset. Globally speaking, the risk-free rate usually describes the return you can get on US Treasury bills, a short-term American government IOU. No sovereign debt – not even that issued by America – is entirely risk-free, but US debt is generally seen as being as close to risk-free as you can get. The US, as the world’s most important economy with the world’s most important currency, is highly unlikely to default in nominal terms (as it can always print its own currency if pushed). For UK investors (who would incur currency risk if buying US Treasuries), UK government-issued gilts would provide the risk-free rate.

The risk-free rate fluctuates over time. Currently, partly because of high demand for “safe” assets following the 2008 crash, but largely as a result of quantitative easing and other efforts by central banks to cut interest rates, the risk-free rate is either negative in “real” terms (after inflation) or even in nominal terms (in some parts of Europe in particular, you still effectively have to pay to lend to governments, as noted in the main story above). As a result, investors who are seeking a “real” return, have been forced to take on more risk – investing in equities or corporate debt, for example – whereas in the days before the financial crisis, it was possible to achieve a 2%-plus real return simply by investing in “safe” government debt.