Emons, The End of the Risk-Free Rate

Ben Emons, a senior vice president and global portfolio manager at PIMCO, argues that we need to adjust our financial models to reflect, as the book’s title states, The End of the Risk-Free Rate: Investing When Structural Forces Change Government Debt (McGraw-Hill, 2013). Emons’ thesis, if sound, is challenging; it calls for a paradigm shift. For instance, equities are priced off the risk-free rate. But if there is no longer a risk-free rate, if (to look only at the domestic market) U.S. Treasuries now carry an element of risk, and presumably an element of risk that is dynamic, how do you calculate the risk premium that is built into a stock price? Equity pricing models need to be redrawn. And options prices would have to be recalibrated as well; the risk-free rate is, after all, an input to the Black-Scholes model. (A proofreading aside, it is not—as it appears in both the text and the index—the Black-Sholes model.)

Unfortunately, Emons’ book doesn’t serve his thesis especially well. He writes like a bond guy, actually like a Dutch bond guy. Which means that his prose is often incomprehensible. To take but a single sentence—and it’s supposed to be a full sentence (p. 62): “In connection is a ‘sudden stop’ at which foreign capital withdrawals that cannot be offset sufficiently by domestic capital.” I assume that “withdrawals” should read “withdraws,” but I can’t parse “in connection.” The book suffers mightily from the absence of a good copy editor and proofreader.

For those who are willing to soldier on, let me try to summarize the author’s argument for his claim that “the present-day risk-free rate resembles an ‘upside-down’ world.” First, the “risk-free rate can be seen as the sum of two kinds of expectations: an expectation of future inflation and future real GDP growth.” With the so-called risk-free rate now at 0, we can conclude that both expectations have been dampened considerably. “That effect gets momentum in case of ‘flight to safety’ during a crisis situation. Because this flight to safety affects the risk-free rate, it also affects risk premiums for other securities.” In 2012 the equity risk premium reached its highest level since the 1960s, nearly five percent. “Based on historical data on equity risk premiums by Ibbotson, at ultra low levels of risk-free rates, the risk premiums represent an ‘old normal.’ It creates the perception that, for example, stocks are dramatically undervalued. That may not be fully correct because historical models are using a risk-free rate based on the assumption of growth rates from better times.” And so, Emons concludes, we get to the upside-down world where the risk-free rate “is distorted on the one hand by flight to safety and central banks; on the other hand, the risk-free rate is assumed in models to be at old school value when growth was higher.” (pp. 29-30)

This book is ostensibly directed at investors who have to make decisions in this new, uncertain environment. I would narrow its audience to exclude all but relatively sophisticated bond investors, academics, and professional money managers. Retail investors in stocks who are not comfortable with the language of bonds will struggle.