Lewis Johnson writes…
PRINCIPLE NUMBER ONE: THE SHORT-TERM, RISK FREE INTEREST RATE ON U.S. TREASURY BILLS SHOULD NOT BE THE HIGHEST INTEREST RATE IN THE DOLLARIZED WORLD.
An uncontroversial principle of investing is that investors seeking safety should accept lower risks for a lower return, and investors seeking to earn better returns should be willing to take more risks. The yields available on the shortest-term U.S. government debt are those most referred to as the return on the risk-free asset. Greater risks that investors could take to earn higher returns come in many forms, as I explain below.
Just to name a few, examples of such risks that should lead to higher returns include 1) duration, the risk of loaning your money out for a longer period of time, 2) credit, the risk of loaning money to weaker quality debtors, 3) equity, which is after all just another form of credit risk, and 4) illiquidity, the risk of not being able to get your money back immediately. Make no mistake: in investing, you take the risk first. Any potential return you may earn comes only later – after you take the risk.
All the potential higher returns named above come from taking higher risks. Isn’t it logical to assume that investors would want to get compensated for taking those higher risks? Otherwise, after all, why not just own the risk-free asset and earn its lower, but safer, returns? This is where the problem lies today, in our inverted yield curve.
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