Which treasury to use for risk-free rate?

The Quest for the Perfect Risk-Free Rate: T-Bills vs. T-Bonds and the Investment Horizon

In the world of finance, the “risk-free rate” is a fundamental concept. It represents the theoretical rate of return of an investment with zero risk of loss. This benchmark is crucial for pricing assets, valuing projects, and calculating required rates of return. But the question arises: which U.S. Treasury security should we use to represent this elusive risk-free rate? The answer, as with most things in finance, isn’t a simple one. It hinges on the investment horizon and the specific risks inherent in the investment being analyzed.

The U.S. Treasury market offers a spectrum of securities, ranging from short-term Treasury bills (T-bills) to long-term Treasury bonds (T-bonds). Each has its own characteristics and, consequently, its own yield. Understanding these nuances is critical to selecting the most appropriate risk-free rate for a given application.

The Allure of T-Bills: Liquidity and Short-Term Focus

T-bills are short-term debt obligations, typically maturing in a year or less. Their yields are often favored as a proxy for the risk-free rate, particularly when dealing with short-term investments or projects. Several factors contribute to this preference:

• High Liquidity: T-bills are highly liquid, meaning they can be easily bought and sold in the market without significant price impact. This liquidity minimizes the risk associated with quickly needing to convert the investment back into cash.
• Minimal Interest Rate Risk: Due to their short maturity, T-bill prices are less sensitive to changes in interest rates compared to longer-term bonds. This makes their yields a more stable and reliable benchmark for the immediate future.
• Reflecting Current Market Conditions: T-bill yields respond quickly to changes in monetary policy and economic conditions, offering a real-time snapshot of the market’s risk aversion.

For instance, when evaluating a short-term loan or assessing the profitability of a project with a horizon of less than a year, a T-bill yield would be a suitable risk-free rate proxy. Its focus on immediate liquidity and stability aligns well with the investment’s characteristics.

T-Bonds: Embracing Maturity Risk for Long-Term Assessments

On the other end of the spectrum are T-bonds, long-term debt obligations issued by the U.S. Treasury, typically with maturities ranging from 10 to 30 years. While they share the creditworthiness of T-bills (backed by the U.S. government), they introduce a crucial element: maturity risk.

• Incorporating Maturity Risk Premium: Longer-term bonds are more susceptible to fluctuations in interest rates. If interest rates rise, the value of an existing bond falls, potentially leading to capital losses if sold before maturity. This risk is compensated for by a “maturity risk premium” embedded in the bond’s yield.
• Alignment with Long-Term Investments: When evaluating long-term projects or valuing assets with extended cash flows, using a T-bond yield as the risk-free rate is more appropriate. It acknowledges the inherent uncertainty associated with longer time horizons and the potential impact of interest rate changes.
• Reflecting Economic Growth Expectations: T-bond yields also reflect market expectations about future economic growth and inflation, making them a more comprehensive benchmark for investments whose returns are dependent on the long-term health of the economy.

For example, when valuing a company with a long-term growth outlook or assessing the feasibility of a large infrastructure project, a T-bond yield would be a more appropriate risk-free rate. It accounts for the long-term uncertainty and the potential impact of interest rate volatility on the investment’s overall return.

The Importance of Matching the Horizon

The key takeaway is the importance of aligning the maturity of the Treasury security with the investment horizon. Using a T-bill yield for a long-term project would underestimate the true risk involved, while using a T-bond yield for a short-term investment might overestimate it.

Beyond the Basics: Considerations for a Refined Approach

While T-bills and T-bonds provide a solid foundation for determining the risk-free rate, there are further refinements to consider:

• Interpolation: For projects with horizons that don’t perfectly match the maturity of available Treasury securities, interpolation techniques can be used to estimate a more precise risk-free rate.
• On-the-Run vs. Off-the-Run: “On-the-run” securities are the most recently issued Treasury securities of a particular maturity, while “off-the-run” securities are older issues. On-the-run securities tend to be more liquid and actively traded, making them a more reliable benchmark.
• The Risk-Free Rate is Not Riskless: It’s crucial to remember that even U.S. Treasury securities are not entirely risk-free. They are subject to inflation risk, and their real return (the return after accounting for inflation) can fluctuate.

In conclusion, selecting the appropriate Treasury security to represent the risk-free rate requires careful consideration of the investment horizon and the specific risks involved. By understanding the nuances of T-bills and T-bonds, investors and analysts can make more informed decisions, leading to more accurate valuations and better investment outcomes. The quest for the perfect risk-free rate is ongoing, but a thoughtful approach, grounded in the principles of finance, is the best path forward.