Is risk free actually risk free? Effect of change in interest rates

As we previously presented in the article Risk free rate (available at http://p-s.com/news/risk-free-rate/), risk free rate is an important component of CAPM model, which is used in the process of estimating the value of companies.

Proxy for risk free rate was historically equal to rates of government bonds of countries with the best credit rating (assed by rating agencies like S&P, Moody’s or Fitch).

Current interest rates are at historically low levels, with some yields already being negative, especially the ones that are considered to be risk free (in Europe that is Germany). In such environment (where interest rates will eventually need to rise) two questions occur:

 

  1. Which interest rates to use as a proxy for risk free rate if one knows that historically interest rates (which were considered risk free) were significantly higher.
  2. Bond yields are sensitive to change in interest rates. Bonds with long duration could lose significant capital value if interest rates rise. In the environment of rising rates (which is imminent) the real question is if current risk free rates are really risk free.

 

Wall Street Journal prepared a Government bond duration calculator where one can simulate the effects of rising/declining rates. Calculator is available at: http://graphics.wsj.com/government-bond-duration-calculator/

Duration does not have a direct impact on the cost of capital of companies but can have significant impact when valuing a portfolio of certain companies such as insurance companies or banks, which have duration and interest rate sensitive instruments in their portfolios. In present time those companies have long-term government bonds in their portfolios, as they are searching for yields, which are especially vulnerable to changes in rates. If rate sensitive instruments are classified as available for sale (are mark-to-market) they can have significant impact on bottom line of the company.