Building BlocksRisk-Free Returns
The Risk-Free Rate
The risk-free interest rate is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time assumed to meet all payment obligations with no chance of default.
In practice, the risk-free rate is generally attributable to the rate of return on US 10-year government bonds since the federal government has the authority to print money if required to meet financial obligations.
Over the past decade, the 10-year Treasury yield has ranged from approximately 0.5% to 3.5%. The current yield falls toward the middle of this range, at approximately 1.6%.
To conclude, in the current market environment, the ten-year risk-free interest rate is ~1.7%. Any riskless return yielding more than 1.7% is inherently superior to the current market.
Fortunately, many households do have near risk-free opportunities that yield more than 1.7% per annum.
Playing defense to the environment marks the first opportunity for market beating performance. Every household goes through a financial rough patch. Employment changes, family alterations, medical difficulties, educational costs, and many hidden opportunities and challenges may arise that require additional funds. During the time period where additional funds are required, there are three paths:
1) A household may borrow funds from some source, which will require an interest rate above 1.6% as the loan will carry risk.
2) A household may sell assets to raise cash, eliminating the asset’s returns (greater than 1.6%), while likely triggering negative tax implications.
3) A household may, if prepared, utilize an emergency cash account to get through the difficult times, completely avoiding the high costs of paths 1 & 2.
Hence, the first active step in risk-free returns is to establish an emergency fund that can weather 3-6 months of expenses in difficult times.
Just like taking Algebra in high school, the same math rules for negative numbers apply to personal finance. Acquiring a positive 10% return on $100 is equally as valuable as eliminating a negative 10% return on $100.
+10% * $100 = $10 -10% * -$100 = $10.
Most households carry some debt at varied interest rates. Mortgages, automobile loans and leases, education loans, credit card balances, home equity lines of credit, and account margin contribute to overall debt load. While each debt has different rates, all require payment above and beyond the risk-free rate.
From the household’s point of view, however, these debt loads are riskless, as the household is required to pay them down … household forfeiture on the debt equates to financial bankruptcy, a losing proposition. While the loan may be risk-free to the receiver, the interest rate is higher than the risk-free market rate.
Household debt therefore requires payments beyond market rates from the perspective of the household.
Once an emergency fund has been established, the next step for investing allows for above market rate risk-free returns from the household’s perspective.
The household should start with the debt that carries the highest rate of interest, often found on credit card balances. Rates on credit cards can easily rise to levels above 20%! Paying off a 20% credit card balance is equivalent to investing in a risk-free asset earning 20% … easily 10x market rates!
While credit cards are generally the greatest opportunity for households, other debt vehicles also offer significant opportunity. There are certainly situations where debt vehicles provide valuable prospects, as educational loans attest. Borrowing funds to invest in personal knowledge and capability can offer a great personal and financial return. At some point, however, paying off debt vehicles will provide simple, riskless, high yield financial returns.
From credit cards to car loans (and leases), education loans, lines of credit, and even mortgages, households often have opportunities for risk-free returns that perform at multiples beyond market supply and demand for US Treasuries.
There is a school of thought that mortgages should be exempt from this analysis, as the interest rates are generally low and interest payments may be tax-deductible. This theory provides it is better to keep the mortgage loan with single-digit interest and invest the proceeds in the market expecting a higher return. This theory does hold water, especially when considering a long-term time horizon to smooth short-term market volatility.
While funds from a mortgage may be invested for market returns above the mortgage rate, this transaction is not riskless for the household. That risk can manifest in two aspects: underperformance of the market and financial difficulties for the household. The risk of market underperformance is greatly reduced with long-term time horizons. The overall return in this situation is the return of the market investment less the mortgage rate, and it is no longer risk-free. The second concern is a potential household difficulty that could impact the ability to meet mortgage obligations. If the emergency cash fund is not large enough to weather the storm, assets may be liquidated to cover costs, often with tax penalties. In this eventuality, liquidations are being made to keep one’s home … a situation I never want to experience, personally.
Many households have great financial opportunities within easy reach. Preparing for difficult financial periods allows for the avoidance of insufficient cash flow. Lack of preparation for such times may require costly asset liquidations, an increase in debt, early taxation, and even tax penalties.
By prioritizing investments into debt reduction, households may realize guaranteed financial returns at multiples of risk-free market rates. Achieving these riskless superior returns is an automatic winning performance that should not be overlooked. The only downside to this awesome opportunity is that the quantity of investment in this endeavor is limited. Once all debts or obligations have been paid down, households must look in other directions for financial returns.