The risk-free rate of return
All economic and financial models assume that there is a risk-free rate of return to be had. This is useful as a reference point when deciding whether to take on additional risk to earn an additional return. For example, if an investor is happy to earn a return of 2%, and this can be had ‘risk-free’, it would be irrational to take on additional risk to earn an additional return that isn’t needed and/or wanted.
Even though economists, financial advisers and investment managers know that there is not a risk-free return available, we assume that there is for modelling purposes. More often than not this rate of return is taken to be that available from government debt; that is, a government bond.
The rationale here is that a government will pay its debts. It will pay both the promised coupon (income), and the return of capital borrowed (the redemption proceeds). Of course, in the case of a government that issues bonds denominated in its own currency, there is no reason why that government would not pay both the income and the redemption proceeds. It can simply print the money to do so.
This does not make the government bond ‘risk-free’, as there are inflation risks. For example, at the moment you cannot buy a UK government bond that yields more than the current rate of inflation. So buying a UK government bond guarantees that you will lose money in real terms (assuming that it is held to redemption, and inflation does not fall). Clearly, there are investors that are prepared to accept this risk.
However, this is a problem no longer confined to economic and financial models. All banks are likely to own ‘developed world’ government bonds, due to them being able to carry these assets as risk-free on their balance sheets. In recent months it has become clear that government bonds are not risk-free, particularly in the Eurozone where governments cannot simply print the money to meet their promises. Banks now have to recognise the ‘risk-free’ fallacy of Eurozone bonds, which will lead to them having to raise fresh capital in the coming months and years.
The risks associated with government bonds are no longer just inflation related. Governments that do not control their own monetary policy may well be forced to default on their bonds in the future.