What is “risk free” ?

“Risk free” has always been an important concept in the investment world as it provides a benchmark for pricing other asset classes that are inherently more risky. Owning a risk free asset basically means that the holder of such an asset can expect to get his money back, no matter what. So which assets are risk free? Historically investors have looked at AAA-rated government debt such as German Bunds and US Treasuries as risk free, as it is hard to imagine that these countries will not honor on their obligations when due. However, this week’s surprise announcement of rating agency Standard & Poor’s, who attached a negative outlook to the AAA status of US government debt - signaling a 1-in-3 likelihood that the rating could be lowered in the coming two years, brings back the debate on what really is “risk free”. Note that the negative rating outlook assigned to US government debt comes on top of the many rating downgrades experienced by the weakest European countries like Greece, Portugal and Ireland, but also debt of stronger countries like Spain and Belgium was downgraded or put on negative outlook. Also Japan’s sovereign debt rating was downgraded and put on negative outlook in recent months.

So what does a AAA rating mean? It indicates that the borrower has an “extremely strong capacity to meet its financial commitments” (S&P definition). To measure this capacity to meet financial commitments, the rating agencies look at the willingness and the ability of an obligor to pay on its debt. One could argue that US government’s ability to pay on its US Dollar denominated debt is not in question, as it could always resort to simply printing more dollars. That means that S&P is questioning the willingness to pay, which is not that strange given the difficulty US policy makers have in choosing between cutting sovereign spending and raising taxes in order to cut the country’s fiscal deficit. In Europe, matters are slightly more complicated, as the countries that participate in the Euro do not have the possibility to unilaterally decide to print more money to pay down debt, which somewhat limiting their ability to pay.

The rating agencies have also assigned AAA ratings to a few corporations, such as Rabobank, Microsoft and Johnson&Johnson, but it must be said there are only a handful. If we would include AA+ or AA-rated companies in the group of most creditworthy institutions, there are significantly more to choose from. Examples are Chevron, Nestle, Novartis, Pfizer, Shell, Total, Wal-Mart and a substantial group of very strong banks and insurance companies. The rating of these companies has been very stable through the financial crisis, a testament to their financial strength. Note that bonds issued by AAA-rated corporates have an average yield that is about 0.5% higher than Treasuries and Bunds, while AA-rated corporate bonds trade about 1% higher. (Source : Barclays Capital index data).

Sovereign debt ratings are on a downward trend given their current high and rising debt levels, and the risk of contagion for stronger countries through providing support for the weaker countries. This increased risk for the historically “ultimate safe haven” countries can also be observed by looking at the price for buying default protection in the credit derivative market. To illustrate, German sovereign protection cost below 5 basis points before the financial crisis, and went up to 44 bps today. A similar picture is visible for the United States with sovereign protection costs up from 8 bps in early 2008 to currently 48 bps. In comparison, Nestle default protection costs 38 bps, with Microsoft at 42 bps and Wal-Mart at 46 bps, so suggesting a lower default risk than the AAA sovereigns! (Source: Bloomberg, 5-year Credit Default Swap spreads)

Would it be conceivable that top-quality corporates can take over the baton of being the “risk free” investment of choice? I would see that as very unlikely. However, it does help for a risk averse investor to look beyond the traditional “risk free” government bonds and add very high quality corporate bonds to their portfolio. These bonds are very liquid and still trade with a significant pick-up relative to government bonds (unlike the CDS). So not only does this help diversify the risk profile of the portfolio, it also enhances its yield!