What is risk-free debt and what is its beta?

Banking & FinanceFinance ManagementGrowth & Empowerment

Risk-free Debt is Hypothetical

Risk-free debt is a hypothetical condition where the risk associated with the debt is zero. In general, there is no such thing as risk-free debt. While the risk of debt may go up and down in comparison, it can never be zero in any condition. This is apparent from the government bonds which carry minimum risk but not risk-free.

  • Even when a collateral is issued against the debt resourced, the debt does not become risk-free. Investors should be aware that the company may be unable to provide the debt back in case of bankruptcy.

  • It is notable that the risk in case of debt is less than the one in case of equity. The cost of equity is more than that of debt. In other words, the interest rate applicable to equity is more than debt.

  • In any case, the interest applied to debt can never be zero. This is so because the investors provide debt to a company in the motive to get good returns on their investment. Hence, the debt can never be of zero interest in practice and so can never be risk-free in the long run.

It is however probable that the investors in debt get some return due to liquidation of the assets of the company in case the company goes bankrupt. However, in case of equity, once the company goes bankrupt, the investors will get zero return. That is also a reason why equity financing is costlier than debt financing.

Beta of Risk-free Debt

It is also notable that since debt-holder investors invest in risky propositions, they need assurance in the form of risk premium. These premiums may be business or financial premiums which are used to minimize the probable risks associated with debt payments. This means that the risks associated with debt can go up and down but can never be zero in practice.

The fact that debt can never be risk-free is also observed in the case of debt having limited upside on interest and limited downside in principle invested. While in the case of equity, there is unlimited upside but when the company goes bankrupt, there is zero upsides in the case of principle. That is why many companies source debt instead of equity because investors are more interested to go for less risk.

The beta in the case of zero-risk debt is zero which is again hypothetical. In the case of debt, the beta may go up from 0 to 1, but it can be 0 in the case of only hypothetical debt situations.

raja
Published on 10-Jan-2022 11:23:55
Advertisements