What if risk-free assets are not free of risk?

What if risk-free assets are not free of risk? With real yields so low it may be that not all portfolios are correctly identifying potential pitfalls.

US government bonds are traditionally seen as the ‘risk-free' assets, though UK gilts, and German bunds are often seen in the same light. It is assumed that these governments will not default, if the bond is due to pay you $100 ten years from now, then you can expect to receive the $100, and the appropriate coupons en route.

But there are two major issues to consider. Firstly, that there is no guarantee that the $100 you get upon maturity will buy the same amount of goods as it does today. US inflation recently breached 7 percent, and currently yields are nowhere near enough to compensate for this reduction in purchasing power.

Furthermore, although it's accepted that you will get paid at par upon redemption, if you wish to sell between now and then you might not get the price that you hope for. With yields so low it feels like the risks are asymmetrical in fixed income.

For those worried about the markets, sitting on the side-lines is not without its own risks. Cash too is being eroded by inflation. A decision not to invest in any assets is a decision to invest in cash. 

Rightly or wrongly, in finance risk is generally proxied by volatility: the more volatile the asset the greater the risk that the price has moved away from the price you anticipate. But this doesn't always tally with the layperson's view - they tend to be more concerned with outright loss of value. 

So, despite bonds and cash being considered low risk, thanks to a comparatively low volatility, currently with low yields and high inflation, there is a material risk of losing both real and market value.

This is not to say that bonds and cash cannot contribute to a portfolio - they can dampen volatility, provide diversification, and in during periods of high market stress, bonds often appreciate as investors look for comparative safety. Cash too can offer optionality to buy discounted assets.

What to buy instead? The world of alternative assets is often misunderstood, even by professional investors. Broadly it can be split into two: absolute return - where a positive return is sought regardless of the underlying market conditions, and real assets - a range of long-only return-seeking assets such as property, infrastructure and commodities. 

Despite there being some very good absolute return strategies, the class is often overlooked because of a few high-profile disappointments. Meanwhile, real assets can often provide inflation-linked or even inflation-beating returns, with asynchronous correlations to other asset classes.

There is no getting away from risk in the financial markets, but taking a broader view of how you think about risk and getting away from the idea that some assets are risk-free can help. Alternative assets might come with higher volatility, but provide diversification, and can offer real returns and a more symmetrical outlook for returns. In an environment like we are living through, alternative assets are a sensible consideration for portfolio allocators.