A BVWire reader recently asked us about how to derive the risk-free rate in the even U.S. debt is downgraded. We turned to Roger Grabowski (Duff & Phelps) for one answer:
During these episodes of flight to quality [securities and assets], one needs to reevaluate simply using the quoted risk-free rate as the basic building block in estimating the cost of equity capital. One needs to identify whether the flight to quality has influenced the market interest rate. On a monthly basis, analysts could follow changes in the market interest rates relative to a rolling average of prior months interest rates and various economic indicators, for example, the flow of funds, the implied volatility derived from options, changes in estimates of inflation, etc. Once analysts suspect that the market interest rates are abnormally low, they could use a build-up approach to estimate a normalized risk-free rate looking at the real rate of interest and inflation estimates.Look for Grabowski’s detailed response in the September Business Valuation Update.
And, Aswath Damodaran posted some of his thoughts (BVR thanks Rod Burkert for pointing us to Aswath's comments) on the same issue late last week on his blog. He discounts the issue of "default," because he says it makes little difference:
The US will not default next week or in the near future, even if there is no debt ceiling legislation passed by August 2. However, the damage has already have been done. The perception that an entity will not default is built not only on the resources controlled by the entity but on the faith that it will always find a way to use these resources to pay its bondholders. Once investors begin debating whether a borrower will default, the faith has been shaken and like Humpty Dumpty, it cannot be put together again.Aswath says that "the market has already downgraded the implicit sovereign rating for the United States. An explicit ratings downgrade will still have an effect on bond prices/rates but it will not be a surprise when it does happen."