The ‘Risk-Free’ Rate is a Dangerous Illusion

Ask any finance textbook or Wall Street analyst what the safest investment is, and you’ll most likely hear the same answer: U.S. Treasury bonds. According to Investopedia, the entire financial system uses the yield on Treasuries as the benchmark “risk-free rate,” because they’re backed by the U.S. government and assumed to carry virtually no default risk.

But here’s the catch: Just because something is low-risk on paper doesn’t mean it’s risk-free in real life.

Inflation, currency volatility, reinvestment risk, and opportunity cost can quietly chip away at the true return you’re getting. And for long-term investors, those risks can add up in surprising—and sometimes damaging—ways.

Key Takeaways

The “risk-free rate” typically refers to U.S. Treasury yields—but they’re not free of all risk.
Inflation can erode the real value of returns.
Holding Treasuries over long periods exposes you to reinvestment and interest rate risk.
Opportunity cost matters: low yields may drag down your portfolio’s growth over time.

What Is the Risk-Free Rate?

In theory, it’s the return you can expect from an investment with no risk of default. U.S. Treasuries are backed by “the full faith and credit of the U.S. government”, so they’re treated as the gold standard for safety.

Why Treasuries?

Highly liquid
Deep, transparent market
No credit risk (in theory)

The risk-free rate is foundational to financial models:

It’s the baseline in the Capital Asset Pricing Model (CAPM).
It anchors discount rates in DCF models.
It helps determine cost of capital for corporations and funds.

But that doesn’t make it bulletproof.

Inflation: The Silent Risk

Let’s say you buy a 10-year Treasury bond yielding 3%.

If inflation averages 2%, your real return is just 1%.
If inflation spikes to 4%? You’re losing purchasing power every year.

Historical Example: In the 1970s, U.S. Treasury yields often failed to keep pace with inflation—especially during the stagflation era. In years like 1974, 1975, 1979, and 1980, inflation rates exceeded 9%, while 10-year Treasury yields lagged behind, resulting in negative real returns. What looked like a “safe” investment on paper quietly eroded purchasing power year after year.

Even today, if you’re earning 4% on a bond and inflation is at 5%, that’s a negative real yield.

Reinvestment and Duration Risk

Reinvestment Risk:

If you hold short-term Treasuries (like 6-month or 2-year), you face uncertainty when they mature. Will future rates be higher—or lower?

If rates fall, reinvesting your principal could generate lower income than you expected.

Duration Risk:

Long-term bonds lock in today’s yield—but their prices drop when interest rates rise. If you need to sell before maturity, you could take a loss even on “safe” government bonds.

Hypothetical Scenario:

You buy a 10-year Treasury at 2% yield. Rates rise to 4%. Your bond’s resale price drops. If you sell early, you lock in a capital loss.

Currency Risk for Non-U.S. Investors

U.S. Treasuries may be stable for American investors, but for international buyers, currency fluctuations can impact returns.

If the U.S. dollar weakens relative to their home currency, they may see lower effective returns—or even losses—despite holding a "safe" asset.

Is the Risk-Free Rate Still Useful?

Yes—but with caveats.

Treasuries still serve important roles:

Short-term capital preservation
Liquidity reserves
Diversification in downturns

Just don’t mistake “low credit risk” for “no risk.”

In reality, the risk-free rate is best viewed as the least risky option among many—not a silver bullet.

Treasury Securities — FAQs

Are Treasuries entirely free of risk?

No. While default risk is minimal, Treasuries remain exposed to inflation risk, reinvestment risk, and opportunity cost, which can reduce their long-term effectiveness.

How do low Treasury yields affect portfolio growth?

Persistently low yields can reduce overall portfolio returns compared to higher-returning assets, representing an opportunity cost for investors focused on long-term growth.

Why do investors continue holding Treasuries despite these risks?

Treasuries remain widely used for capital preservation, liquidity, and diversification, particularly during economic downturns, even if their real returns may be limited.

How do Treasuries compare to corporate bonds?

Treasuries carry very low credit risk and are highly liquid, while corporate bonds can offer higher yields but carry greater risk of default and lower liquidity.

How do interest rate changes affect Treasury holders differently?

Short-term Treasuries face reinvestment risk when rates fall, while long-term Treasuries face price declines if rates rise, both affecting expected returns.

Have Treasuries delivered negative real returns in recent history?

Yes. In inflationary periods, including the 1970s and more recently when inflation exceeded yields, Treasury investors experienced negative real returns.

What risks do Treasuries avoid that other securities carry?

Treasuries minimize default risk relative to corporate or municipal bonds but cannot avoid inflation, reinvestment, or opportunity costs that affect purchasing power.

How should investors interpret the “risk-free rate”?

It may be more accurate to view the Treasury yield as the lowest-credit-risk rate available, rather than as a guarantee of positive or inflation-protected returns.

How does reinvestment timing influence Treasury outcomes?

If short-term Treasuries mature during a period of falling rates, reinvested funds may earn less income, reducing expected returns.

How do risks differ between short-term and long-term Treasuries?

Short-term Treasuries are more exposed to reinvestment risk, while long-term Treasuries are more exposed to duration and inflation risks that can erode real returns.