For people who earn and spend U.S. dollars, treasuries with the given maturity are the canonical risk-free rate. The 10-year rate is given by whatever treasuries maturing in 10-years is, and so on. Some people, generally the type with nuclear shelters full of cans of tuna, object that there’s no true “risk-free” rate. Of course they’re right, the same way you’d be right in saying a giant meteor could smash into east Texas tomorrow and wipe out life as we know it. But, you have to call something “risk-free.” And, in terms of getting $X U.S. dollars in 2030 or whenever, U.S. treasuries give the most certain return.

The “uncertainty-free” rate

It’s a slate of hand trick, equating “risk” with “uncertainty.” Just because you’re certain you’re getting $1000 US in 2030, doesn’t mean you’re any better off then for putting $990 down for it today. More on this in another post, but given enough time, more volatile investments have less “risk” in terms of making you better off in the future.

Inflation and taxes

…the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”.– Warren Buffett[1]

As of 2020, no treasury duration yields above “investor’s misery index.” So, the risk-free rate, although nominally 1-3% for durations of 1-30 years actually carries 100% risk of loss of purchasing power.

Default risk

It’s kind of there. A few years back people debated not paying a few loans during a budget standoff. There will be more budget arguments. And, with foreign citizens and governments holding enormous claims on future US earning power in terms of things like US. treasuries, there’s some weird political risks– it’ll be our kids paying back our debts. On the other hand, Fed-willing, the U.S. government can continue to pay its debt with debt in-kind and a little indirection called quantitative easing. All things considered, all of these risks pale compared to the risk of, say, AAA mortgage-backed-securities defaulting. Or even, appropriately AAA-labeled debt like Microsoft.

Interest rate risk

Over 10-years into historically low-interest rates makes it hard to imagine a future wherein the Fed stops buying U.S. bonds, or something else happens to raise treasury yields. If/when it happens, the bonds you already hold will still give the same coupons and principal upon payback, but will be worth some (maybe very significant) amount less.

All things considered, equating U.S. treasury yields to the “risk-free” rate isn’t perfect. But, with no viable alternative it’s good enough.

[1] Buffett, Warren. Berkshire Hathaway Chairman’s Letter - 1979. www.berkshirehathaway.com/letters/1979.html.