The risk-free interest rate. The conceptual nirvana which underpins much of economic and financial theory. Did this concept make a comeback or what? While the only risk of the 1990s was not owning enough stocks, the new millennium saw the reintroduction of the concept of risk with a vengeance. The NASDAQ fell, inflation rose, and the Treasury announced its eventual resignation from the risk-free asset production business.

In a global financial marketplace the outlook is constantly changing. Opportunities abound, but potential event risk makes the prospect of a shrinking safe harbor quite sobering. Two perhaps unlikely beneficiaries of this environment are TIPS (Treasury Inflation Protected Securities which pay a coupon interest rate in addition to the CPI inflation rate) and STRIPS (the acronym used for zero coupon Treasury bonds which pay a single lump sum at a specific future date). Exhibit I displays the total return of a variety of fixed-income sectors for the first four months of this year.

Exhibit I

The wide dispersion in total return reflects the breakdown of long-standing correlations between sectors. The very usefulness of duration as a compelling systematic risk measure is becoming increasingly questionable. Duration depends upon the assumption that all bonds' yields move together. As the correlations of fixed-income sectors not only diverge from historical patterns, and in some cases actually move in the opposite direction, duration as an overarching risk measure is rendered ineffective. Much like the concept of beta in equity management, duration's usefulness may become more prevalent in theory, replaced in practice by a more comprehensive approach to examining the portfolio asset composition.

The challenge for a traditional spread product manager is to acutely evaluate the alternative fixed-income sectors. In this regard, maintaining a significant position in TIPS and STRIPS has proved a powerful complement to more traditional, higher yielding sectors. The environment that is so beneficial to these assets often tends to be challenging for spread sectors. TIPS and STRIPS have been attractively valued for some time, yet their performance has languished in the inflationless bull market for riskier assets. After all, who needs flood insurance when it isn't raining? But buying very inexpensive insurance is almost never a bad idea. These assets have proved enormously beneficial in this years turbulent times.

TIPS and STRIPS would appear to be unlikely bedfellows. Falling long-term interest rates benefiting STRIPS usually occur as inflation expectations recede, while TIPS' returns tend to benefit as inflation expectations increase. With inflation showing its first sign of life in 10 years, TIPS are an understandable beneficiary. But interestingly enough, the decline in "real" Treasury yields which has helped supercharge TIPS has also helped long Treasury STRIPS. The declining real Treasury yields and the appreciation of these two particular instruments owe much to the need for a safe harbor. Each of these somewhat esoteric fixed-income instruments can play the important role of a risk-free asset for long-term investors. STRIPS are bought to lock in a guaranteed long-term return. TIPS provide protection to investors from inflation. In a global market replete with uncertainty, investors who require the certain assurance of final repayment will gravitate to these instruments. Even reasonably high-quality borrowers will have trouble competing when investment horizons stretch well into the future.

One of the open questions for the bond market is whether we've been in a bull or bear market. Exhibit II displays the path of interest rates for a variety of fixed-income investments. Yields for short-term investments, mortgages and corporates have been rising. Compare that to the rather pronounced yield declines of TIPS and STRIPS. It's not just a matter of relative performance - yields have actually moved significantly in the opposite direction of the broader market.

Exhibit II

Despite the recent swings in prices, the outlook for these products is still bright. Investors with long-term investment needs are facing a veritable sea change in the opportunity set. The relative abundance of AAA-quality debt investments available for storing wealth will now give way to an ever-dwindling scarcity. Long-dated liabilities will be more difficult to hedge as the trade-off between riskless duration matching and higher-returning assets becomes more severe. On the more distant horizon is the possible complication should other high-quality yields decline: The valuation of long-term liabilities (FASB 87 for pensions being a foremost candidate) utilizing high-quality long-term yields as the discount rate could make asset/liability matching more compelling. The old saw that intermediate bonds provide 80% of the return of long bonds with only half of the risk may provide scant comfort if upward liability valuation continues to diverge sharply from broad market returns. In this environment, portfolio construction utilizing TIPS and STRIPS for a broad variety of long-term investment needs should enhance their attractiveness.

The more fundamental issue is simply the higher potential economic and fundamental risk inherent in globalization. Occasionally crises will emerge. The ensuing "flight to quality" could become quite exaggerated without a deep market for risk-free assets. Similarly, the broad asset allocation concept of barbelling credit risk will be called into question. Diversifying a portion of long-term assets into high-yielding securities based on the rationale that the preponderate share of the portfolio is safe may not be feasible. Investors comfortable with accepting higher-yielding credit spread product in combination with risk-free Treasury bonds must carefully re-examine their premise. Portfolio considerations in the absence of a long-term safe harbor are apt to be profoundly different with the prospect of global financial eruptions. As a result, the insurance premium investors might pay for default- free, long-term debt (in the form of receiving lower yields) could be considerable.