Risk in Reverse

by JT McGee

Risk is an interesting animal, especially when evaluated by things prone to error – humans.

It’s especially interesting when you consider how difficult it is to see risk in reverse.

Risk-Free Investments

The US Treasury issues US Government debt determined to be “risk-free” by the market. That is to say that the US Treasury can always deliver dollars to make good on its promises. Basically, you’re always going to get your $10,000 back should you buy $10,000 in government debt.

Risk-free yields are terribly low. You’re looking at an annual return of .75% per year on a 5 year US Treasury Note. Thus, each $10,000 invested will bring $75 per year in interest payments. Your principal ($10,000) will be returned at the time of maturity 5 years later.

Investments without risk obviously earn a lower rate of return. If Treasuries are risk-free, the return should be entirely due to inflation expectations.

Up the Risk-Curve

Let’s move up the risk curve to look at Coca-Cola debt maturing in roughly 5 years. If you were to purchase a Coca-Cola bond today, you could expect a 1.5% yield to maturity, or twice the yield of a US Treasury bond.

A $10,000 investment in Coke bonds brings $150 in income vs. $75 from US Treasuries.

Now, suppose we’re to build a fixed-income portfolio with 5-year bonds. Our choices are between the US Treasury, and Coca-Cola debt. We can earn 1.5% on our capital with Coca-Cola debt and .75% with US Treasuries.

Which do you pick?

THAT Risky?

Is Coca-Cola really twice as risky as the US Treasury? I tried to come up with scenarios in which Coca-Cola will cease to exist.

Any scenario in which Coke fails to pay on its debt, the US Treasury probably wouldn’t exist. In fact, I’m almost thinking that Coca-Cola would be one of the few entities to outlive the US government. It’s global, it’s huge, and it tastes like it’s something from the heavens. Come hell or high water, Coca-Cola is going to fly off the shelves. In fact, I’m thinking hell or high water would be a boon for Coke sales!

So suppose I build a portfolio chock full of Coke bonds. Fast forward 5 years, Coca-Cola is still around, and I’ve received every single cash flow owed to me from my investment. I earn 1.5% on my capital compared to .75% from US Treasuries.

Did I really take on twice as much risk? I mean, really? Now, keep in mind, these bonds are virtually the same except for who is writing the checks to bondholders. If this blog is still around in 5 years, and assuming I remember, we’ll look back at this topic and probably conclude that, looking back, the risks were the same.

This is just another complexity in efficient market hypothesis: every ounce of outperformance is due solely to risk. But how can you judge risk in reverse. It’s almost impossible. There’s really no basis for comparison.

Anyway, I find it an interesting topic: how do you measure past risk? Can you really even measure it at all?

{ 3 comments… read them below or add one }

krantcents July 5, 2012 at 10:31

There are risks in every investment, however the risk is low. Using the yield to determine risk is misleading though as you point out. To assess investment risk, you really need to do much more analysis.

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Mark July 5, 2012 at 11:07

I don’t think most retail investors understand the kind of risks they are taking when they hold US Treasuries. Yes there is essentially no default risk, but smaller investors are almost always in some type of bond fund (will rarely buy individual treasury bonds). I think many people assume that since Treasuries are risk free they can’t lose money, but they fail to understand that future interest rate increases (might be awhile but it will happen eventually) will significantly reduce the value of their bond fund, especially if they hold a significant amount of treasuries maturing in 10+ years.

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PK July 5, 2012 at 23:28

You think Coke is safer that the treasury? Last time I checked, Coke can print sugar water at will (or HFCS water), but the Government can print money. I’ll take the printing press over the vat of C12H22O11.

That said, you can only really measure risk in the past – forward looking risk is just a matter of perception. If a company is in debt and doing fine, a sudden crisis of confidence can suddenly cause it to be knocked out of equilibrium. Now, on the Government side, that’s called hyperinflation… but when your country’s currency is the reserve currency you can take it to the bank that even if it’s debased you’ll get your .75%.

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