Risk-Free Rate: More Than Just a Number

by David Singh and 罗杰成 Roger Loh

A short article written in simple language elaborates on the various constituents of interest rates, yields on sovereign debt with differing maturity and its importance in selecting suitable risk-free rates for corporate valuation in Malaysia and emerging markets.

Risk-free rates (RFRs) are the fundamental building block in corporate finance in valuing financial assets and liabilities. They are a crucial variable in finance and economics. In practice, finance professionals use the yield or interest rate of rock-solid and safe financial instruments issued by governments as a benchmark for RFRs.

This article will first elaborate on the broad elemental composition of interest rates before delving into the many types of RFRs with different maturities. Some guidance and practice recommendations will be given to ease the confusion that many analysts face due to the lack of literature on this broad subject.

Bear in mind that the complexity escalates when selecting suitable RFR for investment analysis in emerging economies or economies with underdeveloped capital markets.

Interest Rates

An interest rate from the perspective of the borrower, is the price paid to borrow money, whereas, from the lender’s viewpoint, it comprises compensation for deferred consumption, loss of purchasing power, and taking credit risks.

The longer the repayment terms of the debt, the higher the compensation is rewarded to the lender for taking the maturity risk.

If the interest rate excludes credit risk, i.e. no risk of repayments, then it becomes default-free. This denotes the certainty of getting paid for the principal and interest amount.

The various constituents of interest rates for any debts, in general, comprise short-term default-free rate, maturity and default premiums, as shown diagrammatically in Figure 1 below.

Sovereign Debt Rates

The quotes for potential sovereign debt rates come in many maturities. There are overnight rates, 90-day bills, and longer maturity ones go from one year to thirty years or more, as well as various coupon payments (see Table 1). Each of the yields provides information to determine the discount rates for financial instruments with different maturities.

Let's start with the overnight interest rate. This is an interest rate dictated by central banks at which banks lend and borrow from each other against excess funds held with the central bank. While it is called the Overnight Policy Rate in Malaysia, it is known as the Federal Funds Rate in the United States (US).

Then, there is the Malaysian Overnight Rate (MYOR), administered by Bank Negara Malaysia. Its US counterpart is known as the Secured Overnight Financing Rate (SOFR), administered by the Federal Reserve Bank of New York.

These benchmark interest rates, designed to exclude credit risk and maturity premiums, are mainly related to macroeconomic factors. Financial institutions and investors in sovereign bonds utilise these rates as a benchmark to borrow and lend within their respective markets.

There are yields on sovereign bills that can serve as RFRs, too. Sovereigns also issue longer maturity bonds that can be used as RFRs, with some having semi-annual coupon payments while others are zero-coupon or inflation-indexed. In Malaysia, there are neither zero-coupon nor inflation-indexed sovereign bonds. However, conventional and Islamic bonds (Sukuk) are issued in light of the dual banking system.

Which RFR to Use?

The glaring difference observed in Table 1 is the US inverted yield curve and the different yields with differing maturities for each currency. This brings ambiguity to many analysts in selecting a suitable RFR for analysis, say in valuation or determination of hurdle rates.

The foremost rule is to use the RFR that matches the cash flow duration. If the cash flow has a duration of only 3 years, then the suitable RFR to be adopted can be the 3-year bond yield. Similarly, when valuing a European option, the suitable RFR shall be the zero-coupon yield that matches the option's cash flow.

Equally important is to ensure the use of RFR for the currency of cash flow. The US RFRs cannot be used as it is, presuming that the cash flow is in Malaysian Ringgit (MYR), unless the right USD/MYR exchange rate is applied to convert the MYR cash flows.

In addition, though Malaysian sovereign bonds are of investment grade, the yields are not truly RFR, as they can muster only an A3 credit rating by Moody's Investors Service. As such, these bonds are not devoid of credit risk.

Corporate finance literature will also tell that coupon-paying sovereign bonds comprise reinvestment risk and thus are not truly RFRs and that the actual RFR rate is zero-coupon yields.

The Practice

Many practitioners do not take sovereign zero-coupon yields to determine RFRs for corporate valuation, as the difference between coupon-paying sovereign bonds is insignificant. This is evident as shown in Table 1, depicting rates of US treasury coupon and zero-coupon bond yields.

It is common practice to match the duration and currency of the cash flows in determining the right RFR to use. Using the 10-year sovereign bond yield as the RFR is an acceptable practice for corporate valuation or determining hurdle rates.

This decision is often based on a number of considerations aimed at aligning the characteristics of the selected RFR with the underlying cash flows being discounted, such as:

One, in a typical discounted cash flow valuation, the estimated cash flows often extend over a long-term horizon. As a result, a 10-year sovereign bond yield is frequently chosen to better match the duration of these projected cash flows.

Two, in some jurisdictions, including the US, sovereign bonds are issued with extended maturities of 20 or 30 years, but the 10-year sovereign bond yield is generally preferred for corporate valuation. This preference is informed by the relative scarcity of other foreign sovereign bonds with durations exceeding 10 years, making the 10-year yield a better benchmark to quantify a default or credit risk premium in emerging markets.

It is equally important to ensure that the RFR applied is sanitised of credit risk. The Malaysian sovereign bond carries an element of credit risk with its A3 rating and, thus, does not represent as a true RFR. This is also a common issue with many other sovereign bonds in emerging economies.

Some of the good practices in determining RFRs to solve this conundrum are as follows:

First, if the cash flow currency is in USD, then it is suitable to use the RFR of the US treasury yields that match the cash flow duration.

Second, if the cash flow currency is not in USD but in another currency with an AAA rating, for example, Euro (EUR) or Australian Dollar (AUD), the suitable RFR for the respective currencies should be applied.

Third, if the cash flow currency belongs to an emerging sovereign that does not attract an AAA rating, it is a good practice to sanitise the RFR for the emerging economy of credit risk to reflect true RFR. (Some practitioners even sanitise the RFR of an AAA-rated sovereign with CDS spread to reflect true RFR, but we believe this is an overstretch as the CDS spread represents counterparty risk.)

Fourth, it is a good practice to sanitise the sovereign CDS spread of counterparty risk. A proxy for this can be the average CDS spread of a sovereign with an AAA rating.

Fifth, if the emerging sovereign has poor capital markets or no sovereign bonds issued or unrated, it may cause difficulty in determining its true RFR. There are two options to resolve the complication:

One, estimate the RFR of the emerging country by adding its expected inflation rate to the real RFR of an AAA-rated sovereign, or

Two, convert the cash flow to an AAA-rated sovereign currency and use the RFR of the AAA-rated sovereign bond.

For example, suppose a valuation of a corporation is done in Papua New Guinea, it is wise to instead value it in AUD based on its proximity, influence, and size of trade with Australia.

Throughout the process of determining a suitable RFR, it is crucial to always bear in mind that the RFR should only comprise the default free rate relevant to the duration and currency of the cash flow. It is not the vehicle for conveying concern about the riskiness of the cash flow.

Conclusion

In the financial journey, the concept of RFR stands as our guiding North Star, anchoring everything in corporate finance, from intricate corporate valuations to impairment assessment and investment decisions.

This article has untangled the complex tapestry of interest rates, shedding light on the landscape across various maturities and currencies. In the fluid finance realm, selecting the right RFR is far from a one-size-fits-all exercise. The nuanced interplay of various factors that inform the choice of an RFR is not just pivotal - it is essential. May your corporate finance decisions be as sound as the RFRs that bolster them.

References

Bank Negara Malaysia. 2022. Size and Market Share Factsheet on Malaysian Government Investment Issue (“MGII”). Bank Negara Malaysia.

Damodaran, Aswath. 2008. Damodaran on Valuation. 2nd ed. Hoboken: John Wiley & Sons.

Fitch Ratings. 2023. “International Local and Regional Governments Rating Criteria.”

Loh, Roger. 2023. “Beyond the Ceiling: Rethinking the Risk-Free Rate.” BVIUK.

Macquarie Business School. 2019. “Debt Capital Markets.” Lecture Notes, Macquarie Business School.

Thomson Reuters. 2023. “Practical Law: Risk-Free Rate (RFR).”

van Binsbergen, Jules H., William F. Diamond, and Marco Grotteria. 2022. “Risk-Free Interest Rates.” Journal of Financial Economics 143 (1): 1–29.

This article was first published in The Malaysian Accountant Journal in the November / December 2023 issue (click here) in collaboration with the Malaysian Institute of Certified Public Accountants.

The views expressed here are the writer's own and do not reflect the opinions and views of any organisation or its members.