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The Death of the Risk-Free Rate of Return

How does the absence of a risk-free rate of return impact investment thinking?

Much of modern finance theory is built upon the concept of the risk-free rate of return. But what happens when the real world ceases to offer a positive risk-free rate? In this provocative paper, Chris Brightman argues that the death of the risk-free rate changes how we should think about monetary policy, investment models, long-term returns and portfolio allocations.

Man walking across rocks

Death of the Risk-Free Rate (Research Affiliates, 2016)
Chris Brightman argues that the absence of a risk-free rate of return should impact the way in which we view not just monetary policy, but also investment risk and portfolio allocations. Investors should abandon their previous understanding that a positive real risk-free rate of interest underpins long-term returns, and instead protect themselves against the risk of a secular upturn in inflation as monetary policy moves into its next phase.

Debt, Growth and Investment Returns: The Inconvenient Truth (MFS, July 2016)
High government debt ratios make it very difficult for countries around the world to loosen fiscal policy and stimulate growth. Yields will remain low for years to come and investors are encouraged to rein back their expectations to reflect the current economic conditions. MFS encourages investors to focus on real rates of return (rather than nominal assumptions) and to beware of chasing yield - and consequently mis-pricing risk.

Expected Future Asset Class Returns for 2016-2020 (Robeco)
In this excellent 120-page document, Robeco present their forecasts for expected returns for major asset classes during 2016-2020. They also set out in detail the building blocks underlying these forecasts. They argue that longer-term forecasting is more reliable than short-term forecasting.

Equity/Bond Correlation: Historical Reflections and Future Prospects (BlackRock, July 2016)
The correlation between equity and bond markets is of vital importance to asset allocators; for risk control and portfolio construction, for assessing the market outlook, and for building models of how markets work (equity market valuation models, for example). In this 6-page paper, Nuno Luis and David Caplan of BlackRock examine the history of the equity/bond correlation and discuss the likely future path.

What if we live in a low-return world? Implications for US pension funds (JP Morgan, 2015)
In this paper Michael Cembalest and Anthony Gould examine the trend for long-term growth among asset classes, as well as implications and solutions for pension funds. Cembalest investigates how long-term interest rates are affected by trends in global demographics, growth, and productivity, while Gould investigates key solutions and considerations to overcome the implications on pension portfolios of a low-return paradigm.