What is Risk-Free Debt?

Executive summary

Risk-free debt is deeply embedded in financial markets as short-hand for high-quality liquid debt that typically retains its value over time. Also, it’s referred to as debt that has a zero chance of defaulting.

Key learning objectives:

  • Define Risk-free debt and identify its properties
  • Be able to calculate expected return using CAPM
  • Define HQLA, and explain their benefits
  • Discuss the different types and examples of HQLA

What are the Risk-free debt properties?

  • Increases in value at times of market stress as investors seek its safety to protect them from volatility
  • Referred to as safe-haven assets – investors are sure they’ll receive their money back regardless of market conditions
  • Typically offer low returns

How can investors calculate the returns they should demand?

Capital Asset Pricing Model:

What are High-Quality Liquid Assets?

Assets that are:

  • Unencumbered
  • Freely transferable
  • Well diversified
  • Easily and immediately converted into cash
  • Capacity to generate liquidity remains intact, even during periods of severe market stress

What are the benefits of HQLAs?

  • Low risk and low volatility
  • Ease and certainty of valuation
  • Low correlation with risky assets
  • Are listed on recognised exchange
  • Have an active and sizeable market
  • Flight-to-quality characteristics (go up in value in stressed market scenarios)

What are some examples of Level 1 Assets?

  • Coins and banknotes
  • Funds held in central bank reserves
  • Debt securities representing claims on zero risk-weighted sovereigns, central banks and some public-sector entities
  • For domestic banks, sovereign debt of their home country

What are some examples of Level 2A Assets?

  • Securities representing claims on, or guaranteed by 20% risk-weighted sovereigns, central banks, public sector entities or multilateral development banks
  • Plain-vanilla debt securities issued by non-financial corporates and covered bonds
  • Corporate debt securities that have a long-term credit rating from a recognised rating agency of at least AA-, or a short-term rating equivalent in quality to the long-term rating.

What are some examples of Level 2B Assets?

  • Residential mortgage backed securities that meet stringent conditions
  • Non-financial corporate debt securities including commercial paper with an eligible long-term credit rating of between A+ and BBB-, or with an internal PD assessment consistent with this level of credit rating
  • Exchange-traded common equity shares, not issued by a financial institution, that are included in the major stock index of local jurisdiction, and denominated in the local currency of a bank’s local jurisdiction
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