April 24, 2025 l Manila Bulletin
In business school, one of the fundamental lessons is that the greater the risk you undertake, the higher the return you should anticipate. Government-issued bills, notes, and bonds represent essentially sovereign risk and are typically regarded as the safest instruments in the market, consequently offering the lowest interest rates. Slightly riskier are the debts issued by blue-chip companies, which yield a marginally higher interest rate, followed by the borrowings of lower-tier or higher-risk companies that offer a more substantial interest rate.
What drives this risk-return relationship? Fundamentally, weaker companies carry a greater risk of default on timely interest payments or even principal repayment upon maturity. To attract investors to these lower-quality debt instruments, issuers are compelled to offer a higher rate of return, compensating investors for the increased risk they assume. This, of course, assumes that these companies still operate with manageable risk under normal circumstances.
Numerous types of risk must be considered when determining the appropriate rate of return, including business, liquidity, economic, succession, government, environmental, fire, and even natural disasters. However, certain risks defy adequate compensation through higher returns, such as fraud, mismanagement, incompetence, and criminal acts. In situations involving fraud or intent to defraud the public, no premium on return can ever suffice, as the entire principal is at risk of being lost.
Beyond risk, other factors influence your decision on an acceptable rate of return, such as alternative investment options, the inflation rate, and associated costs like withholding tax on earned interest. Some investments, like gold, non-rental properties, and certain equities without dividends, only offer potential capital gains. The real challenge lies in inflation, which can erode your principal’s value. For instance, if the inflation rate is five percent and your net-of-withholding-tax return is four percent, your principal diminishes by one percent annually.
While assessing whether the rate of return adequately compensates for the risk is subjective, certain benchmarks can guide you. For example, major credit rating agencies like S&P, Moody’s, and Fitch assign credit ratings to most debt issuers, reflecting the perceived risk associated with the company’s ability to repay its debt. Consequently, companies with higher credit ratings should be able to borrow at a lower cost than those with lower ratings, and we would expect companies with the same rating to have similar borrowing costs.
Understanding the level of risk involved in any investment and ensuring you receive a fair return is crucial for your financial well-being. Investing the time to explore alternatives and comprehend where your money is going is a worthwhile endeavor.
***The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as FINEX. For comments, email georgechuaph@yahoo.com. Photo is from Pinterest.