Looking beyond inversions and market volatility

Key takeaways

  • The risk-free rate reflects “systematic” risk within a specific economic area or country.

  • Fluctuations in the risk-free rate can have a meaningful impact on the price of publicly traded fixed income and equity securities.

  • Yieldstreet’s products strive to have more limited sensitivity to changes in the risk-free rate, as well as public market volatility.

What is a risk-free rate?

Imagine you’re spending $100 to purchase your favorite pair of shoes. Your best friend asks you to wait instead and give him the money, and pledges to give it back to you a month later with an additional two dollars as a reward for your patience. If you agree, you are giving up your immediate satisfaction for a delayed one, in exchange for what can be called a $2 interest payment. 

The follow-up question is what determines the right amount of interest that can successfully convince you to wait and lend the money rather than using it for your own personal satisfaction. That number is likely to be the result of a combination of various factors, some of them closely related to your friend’s personal financial situation and repayment capacity. Does he have a job? Does he usually pay back his debts? Others are related to macroeconomic factors mainly projected inflation and growth. In a simplified way, the latter – the amount of interest that it takes to offset the general risk that affects all credit transactions – – is known as the “risk-free rate.” It is the rate that is implied to cover “systematic” risk within a specific timeframe. For example, if most investors start believing inflation will increase in the US in the near future, the US risk-free rate over the same timeframe will most likely also increase. 

Central banks use complex mathematical models to determine what the right “risk-free” rate should be at any given time but even central banks, using these models, don’t always get it right. The idea of the risk-free rate is intuitive: you should get paid to wait, and you should be – compensated enough to offset the loss of value, while you wait, as well as the opportunity cost.

Enter the yield curve

The interest rates required to offset systematic risk for different time horizons together form a “yield curve,” which is shown in the graphic below:

For instance, 1.6% is the rate that markets, as of March 25, 2022, believe is fair that anyone should pay for “risk-free” debt (hypothetically, a US government security that is supposed to have the full credit backing of the US Treasury) maturing in September 2022. If the risk-free security matures in June 2023, the “fair” market rate would be 3%. 

These are not just abstract quantities, – they are – relevant for financial market players. – The yield curve is used to directly price existing US treasury securities, but it also serves as the base to indirectly price all sorts of instruments, including, crucially for consumers, mortgages and other types of loans. 

To price these other securities that are inherently considered less safe than government bonds you have to add “unsystematic” risk – which is risk related to a certain company, asset or specific debt issue – to the risk-free rate. You can then construct a yield curve, theoretically, for any debt instrument transaction, or company. If the unsystematic risk for Company A is believed by analysts to be – 3% for one year, 4% for two years and 5% for five years, the curve for the debt issued by that company is going to reflect these higher rates:

The (hypothetical) red curve in the graph above is constructed by putting together the rates that investors will require to buy Company A’s debt across different maturities (the risk-free rates and the spreads). Company A wants to sell bonds that mature in September 2022? It will have to pay back principal + 3.1%, which is 150 basis point higher than if the debt was a US Treasury security (the “risk-free” rate). 

Central banks tend to set the short-term part of the risk-free yield curve via open market operations (the purchase and sale of short-term government securities). In addition, market participants and central banks together can influence long-end rates via demand-supply. So what happens when the risk-free rate – increases?

If you own a company-issued security that has a five year duration (that is, a debt that matures in five years) and you’re getting paid a 5% coupon (5 cents for every dollar invested) every year, for five years, your investment can be very sensitive to changes in the risk-free rate. Assume the risk-free rate is 3%, but because of projected higher inflation, it increases to 4%: the fair value of your future payments will suddenly decrease in value, and not by little. Yes, you make 5 cents, but you could have made 4 with a risk-free investment, without taking on company risk at all. And since your company risk – which determines the “spread” over the risk-free rate, the amount of money you’re asking in addition to the take on that borrower risk – hasn’t decreased from the time you made the investment, you end up not being properly compensated overall.

Incidentally, your investments in equities are also sensitive to movement in interest rates. As stock valuations are a function of discounted future cash flows (DCF), an increase in the discount rate can cause a decrease in their fair value, as calculated using a so-called DCF model.

Currently news outlets and analysts are talking about an “inverted” yield curve for the risk-free rate (in the US, the US Treasury securities market). The concept is intuitive and can be clearly visualized in the graphic below, which shows the prevailing rate at different maturities. There is clear evidence of an “inversion” – if you were to purchase a risk-free security maturing in December 2023, your required interest rate would be 3.1%, while for one maturing in March 2024, the required rate is only 2.5%.

An inverted yield curve signals that market participants believe the interest required on short-term bonds should be higher than the interest required on longer-end bonds. This situation usually points to growth and inflation peaking in the near future, and then decreasing further down the road. An inverted yield curve may in certain circumstances point to a potential recession – a phase of the economic cycle where growth and inflation are more subdued – after a period of strong growth and inflation such as the one we are currently experiencing. 

How Yieldstreet may help mitigate market volatility risk

You can already intuitively grasp how Yieldstreet can offer a viable alternative to the volatility caused by fluctuating risk-free rates. In other words, we believe a Yieldstreet investor need not be as concerned about interest rate volatility, inflation, and other macroeconomic events as an investor in public equities and public fixed income markets. 
One reason is the substantial spread between Yieldstreet investments’ target yield, and the risk-free rate. Without resorting to math, it is not hard to see how a 1% increase in the risk-free rate has a more limited effect on a product with a 12% target yield compared to an instrument with a 5% target yield. The “premium” reflects the additional risk from the deal/company/invested asset, but an accurate due diligence can help reduce that risk. Our team’s strict due diligence process is highlighted here. In addition to that, holding the investment to maturity means that you most likely don’t have to worry about temporary fluctuations, as long as there is full repayment at maturity.

Sign Up On Yieldstreet

Some of Yieldstreet’s products offer cash flow (income), others a bullet payment at maturity (growth) that includes the compounded target interest. But all of them give you higher exposure to more diverse sources of risk and return compared to public equities and fixed income, meaning that while part of your portfolio – the one invested in public securities – may suffer from short-term volatility, your Yieldstreet portfolio value will likely be much less sensitive to it. 

Learn more about the ways Yieldstreet can help diversify and grow your portfolio.

References:

1. https://www.investopedia.com/terms/d/dcf.asp
2. Analysts disagree on whether the current inversion will actually lead to a recession. “U.S. five-year yields climbed as much as 12 basis points to 2.67%, rising above those on 30-year bonds. The spread between five- and 10-year Treasuries inverted earlier this month. While the latest inversion has traditionally been seen as a recession signal, that may not be the case now because Fed policy has been so loose, according to Mohit Kumar, a managing director at Jefferies in London.” – Global Bond Rout Deepens on Fear Rate Hikes Will Stoke Recession 2022-03-28, Bloomberg.
3. All these macroeconomic changes are causing investors to demand a higher risk-free rate. The 10-year yield was at approximately 1.5% in November and is as high as 2.5% as this piece is being written. The increase in the rate has likely had an outsized negative impact on the price of debt securities that pay – say – a 3% yield for the same timeframe.
4. But if you want to dive in, https://www.investopedia.com/terms/b/bond-valuation.asp

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