Riskless
On Monday 25 April, the rating agency Standard & Poor’s placed US debt on credit watch. While Greece, Portugal and Spain have (almost) accustomed our European minds to this type of event, in the US, Standard & Poor’s has made a number of financiers cough.
The implications of the downgrade on US tax policy but above all its symbolic nature have been widely commented on: Standard & Poor’s decision seems to sound the death knell for the risk-free asset. Indeed if Uncle Sam himself is no longer an irreproachable borrower, then who is?
The question is not as simple as it seems. One of the many consequences of the 2008 crisis is that it redistributed risk assessment and classification in the minds of investors. In the universe of debt, who would have thought just 10 years ago that companies could borrow at more attractive rates outside their domestic market? Upheaval in state debt has caused a new hierarchy to emerge. If REPSOL (Spanish oil group) can borrow at better rates than the Spanish state, then the risk-free rate (which is theoretically the state) is in a bad shape or becoming extinct.
It remains to be seen whether the risk-free investment has ever existed? In finance academic books no doubt! It is defined as being “an asset with guaranteed flows whose issuer cannot default”. Russian bonds that have often been gathering dust in the attacks of our forefathers, are a reminder that a state guarantee is not enough to make a bond totally risk-free.
And yet savers continue regularly to believe in this notion of a risk-free asset, and even to abusively extend its initial definition. Guaranteed-capital structured products at the root of success stories for a number of major banks are a recent display of this search for the holy grail. The Lehman Brothers’ bankruptcy in 2008 was a reminder to owners of these products that the capital is not always guaranteed, especially when whoever insures the guarantee disappears!
If we rule out state assets and structured products, where can a risk-free investment actually be found? In Paris property, some would say, quickly forgetting the 1990s. In gold others proclaim, forgetting the depression that dogged the metal from 1982 to 2002. The number of examples of assets that are thought to be risk-free but actually aren’t is huge. A fanciful notion indeed!
In reality, only more-or-less risky assets exist, the hierarchy of which constantly changes over time. Rather than seeking a risk-free solution, it is far more useful to seek the best type of risk. This is exactly what “great” investors do! Whether an equity investor like Warren Buffet or a bond investor like Bill Gross (the star manager at PIMCO), everyone is looking for an allocation on the best risk.
When Bill Gross switches out of US debt and into corporate bonds, he allocates capital entrusted to him to what he considers the most attractive bond asset. Similarly, when Benjamin Graham laid the foundations of value investment with his famous “margin of safety” (2), he too was aiming for the lowest risk, bearing in mind that zero risk does not exist.
The risk-free investment is like the dahu in the French mountains. There is no point hunting it, it does not exist!
(1) Source: Finance d’Entreprise de Pierre Vernimmen, Dalloz
(2) The Intelligent Investor