One of the cornerstones of corporate finance is the concept of a risk-free interest rate. For many decades, US treasuries were considered risk-free. All other sovereign risks were priced off of US treasuries. After all, who could have a lower chance of default than the mighty US Government?

Corporations, in turn, in each country, could only have higher risk than the underlying government and currency in which they conduct business, their risk (and hence return) could only be at a premium to sovereign treasuries in their respective home countries.

This may no longer be axiomatic. The world is rapidly changing. Rating agencies, such as S&P and Moody’s, are now allowing for the very real possibility that US treasuries may lose their coveted AAA status. If the US government does not approve lifting the ceiling of its self-imposed $14.2 trillion borrowing limit, it is likely to cease making certain payments by August, 2011. While no one doubts that the US government is economically capable of servicing its debt in the short- to medium-term, a lack of political consensus to raise the ceiling would create a politically induced default. 

Vicious circles

Long-term, if high deficits continue, the US may move into territory where it may even lose its ability to safely service its debt. The current ratio of federal government debt to GDP is upwards of 70%, and if current trends continue, could exceed 90% within the next few years. This is aggravated by the fact that total US debt (federal debt, plus state and municipal debt, corporate and individual debt) is already in the range of 300% of debt/GDP, and this does not include unfunded government obligations, (for example, those related to medical care, pensions, etc.). 

When debt levels become this high, borrowers seek to pay down debt (to the detriment of investment and consumption), which creates an environment not conducive for growth. It is far less painful to reduce the debt/GDP ratio by growing GDP then by shrinking debt. But the higher the ratio becomes, the more likely it will require painful debt reduction (deleveraging) to bring the ratio down, rather than growing one’s way out of the problem. This risks creating a vicious circle, where debt contraction may trigger GDP contraction, creating a downward spiral.

There is another vicious circle potentially in the making. US treasuries have been at historically extremely low interest rates over the past years, as a result of quantitative easing. Yet despite near-zero interest rates, the US deficit continues to burgeon. If interest rates on treasuries were to increase by a mere percentage point, (for example, from approximately 3% to approximately 4%), this would raise by one third the cost of issuing new debt or refinancing old debt. This would further diminish the ability of the US government to service its debt, potentially triggering a downgrade by rating agencies, which could result in a further increase in borrowing costs. 

What if treasury interest rates were to spike into the double digits? (It has been north of 16% in my living memory.) You get the picture.

A race to the bottom

The US government has nevertheless been spared a negative spiral, in part by the fact that there have been so many crises over the past years (Hungary, Dubai, Iceland, Greece, Ireland, the Jasmine revolutions, Portugal, now potentially Spain or Italy), that US treasuries appear relatively safe compared to other major currencies, given the sheer size of the US economy, and the status of the US dollar as a reserve currency. Ask not whether the dollar is stronger than the euro, or vice-versa. Ask which is less weak?! At times, over the past few years, it has appeared as though the dollar and the euro have been in a race to the bottom.

So, I come back to the question: Where does all this leave practitioners of corporate finance? Every valuation in the world using the most common methodology (Discounted Cash Flow) calculates a cost of capital that assumes that US treasuries are risk free. But how can US treasuries be risk free if they risk losing their AAA status? And if the US government risks defaulting on its debt? 

In the same way as a compass loses its accuracy when a navigator approaches a magnetic pole, the riskier US treasuries become, the more corporate finance practitioners risk losing their compass or accuracy in valuations. Let me ask a question that illustrates the absurdity: If we are to value an asset or company that derives its cash flow in a country where treasuries have less risk of default than the US treasuries (that is, less risk of losing their AAA credit rating), it is intuitively wrong to add a risk premium or even to price treasuries at the same rate as US treasuries. Would not such an argument be even stronger if the US dollar actually lost its AAA status?

Thorny issues

These are thorny issues, with no easy answers. If I had to offer a prediction as to what were to happen if the US credit rating was downgraded a notch from AAA, it would be that the US treasuries would, at least for a while, continue to play the role of the “risk-free rate” for valuation purposes, because of the sheer size of the US economy, the status of the US dollar as the reserve currency, and the time necessary for a consensus to develop as to what might be an appropriate alternative. 

If US treasuries lose their AAA status, how long they remain the “risk-free” rate for the sake of corporate finance valuations will depend on the seriousness of the credit degradation, the future outlook for treasury risk, a big dose of market psychology, and power politics—in other words, quite unpredictable.