Definition of risk-free rate

The risk-free rate, or as it is sometimes known, the risk-free interest rate, is the yield on high quality government bonds. For most investors the US Treasury yield is the risk-free benchmark against which other assets can be measured. Pension funds use the the risk-free rate to  to discount their liabilities to present value, so they can compare them with assets and get a funding ratio. They use it for their own internal purposes. They use a different rate to discount liabilities for the purposes of the deficit companies have to report on their balance sheets.

Risk-free rate in the news

The unprecedented downgrade of US debt by the ratings agency Standard & Poor's in 2011 – although in practice it had virtually nil impact on the issue of Treasuries – sparked serious discussion on whether it was appropriate to use continue to use US Treasury yields to determine the risk-free rate. Meanwhile, in 2012 attention was turning to pension funds. The main concern centred around the rise in liabilities due to falling yields on high quality bonds, which raised the deficits of pension funds and required employers to put in more money. There has been pressure in the UK to let funds smooth the discount rate and in the US and other countries they have moved to do this, to take the pressure off employers.