Risk-free assets often play important roles in the financial system. For example, lenders looking for high-quality collateral might accept risk-free assets like Treasury bills. That way, they can easily rely on the known value and stability of their collateral in case the borrower defaults. In securities lending agreements, an investor might lend stock to a borrower who then provides risk-free assets as collateral. Risk-free assets also can help financial services organizations like banks meet financing and regulatory requirements. For example, banks need to maintain a certain level of liquidity to protect against a crisis, so they might hold U.S. Treasury bonds to meet these requirements.
How Does a Risk-Free Asset Work?
A risk-free asset can mean different things to different investors. In the U.S., it’s common for Treasury bonds to act as risk-free assets, as discussed. But some investors might consider short-term Treasurys, such as a one-month Treasury bill, to be risk-free, whereas others might consider five- or 10-year Treasury bonds to also be risk-free. In other countries, a government bond might not necessarily be considered risk-free, especially if that country has a higher risk of default. So, in some respects, a risk-free asset is in the eye of the beholder. That said, assets like U.S. Treasury bonds are generally accepted by market participants to be risk-free. So these bonds might also be used as a risk-free benchmark. A five-year corporate bond might be compared against a five-year Treasury bond. An investor then has to decide if the risk presented by that corporate bond, even if it has a higher interest rate, is worth taking over the risk-free asset. Similarly, investors might use risk-free rates in comparison with equities’ performance. Suppose an investment manager has only been providing, say, a 3% annual return from stock mutual funds over the past few years. Meanwhile, had the investor been holding a portfolio of U.S. Treasurys, they might have earned, say, 2% per year. The investor then might question whether it’s worth sticking with this investment manager, who’s barely providing more return than risk-free assets. By investing in equities, which can easily drop in value, the investor is taking on more risk. So, they might prefer to go the safer route with risk-free assets, or they might choose a different asset manager whose performance is worth the risk.
What Does a Risk-Free Asset Mean for Individuals?
Understanding what a risk-free asset is can help individuals make more informed investment decisions. Investors need to balance risk and return, so you may want to look at what risk-free assets like Treasury bonds provide in relation to other investments you’re considering. That’s not to say that you need to take the risk-free approach, but you might want to use these assets as benchmarks. If you’re averse to investing in the stock market, for example, but you don’t want inflation to eat away at bank account savings too much, you might decide to invest in Treasury bonds. Remember, however, that even if an asset is considered risk-free, arguably nothing is truly risk-free. Even cash, as mentioned, carries the risk of losing value because of inflation, and it’s also possible that inflation will outpace your investments in Treasurys.
