Businesses can be funded by various means, but most forms of funding can be classed as debt (capital lent to the business) or equity (a slice of ownership in the business).

Holders of debt expect to be paid a regular return for the capital lent to the firm. Equity holders expect to be remunerated either via a regular return (dividends) from current profits or using those profits to grow the value of the business, meaning their equity is worth more.

Debt and equity have quite different claims over the assets of a business, as outlined in the balance sheet. These claims mean that debt and equity investors are subjected to different levels of risk and should be compensated accordingly. It becomes even more important to understand this dynamic when investing in a rising (or falling) interest rate environment, which constantly alters the risk-adjusted returns between debt and equities.

Debt vs equity

Debt represents borrowed capital that a company must repay with interest. It typically takes the form of loans, bonds, or other financial instruments with a fixed or variable interest rate. Debt holders are essentially creditors of the company; they lend money to the business in exchange for a promise to be repaid with interest. Debt holders have a legal claim to those payments. High levels of debt and interest can create financial strain for a company and if it fails to meet its debt obligations, it can face legal action, bankruptcy, or the liquidation of assets to repay creditors.

Equity represents ownership in a company. Equity holders have a claim on the assets and earnings of the business, after all debts and obligations have been paid. Equity investors receive their returns through dividends or capital appreciation as the value of their shares increase. If the company performs well, shareholders benefit. However, they also hold all the residual losses if the company fails. Shareholders typically have voting rights in the company which allows them to influence strategy and capital allocation.

Higher returns, riskier assets

The risk premium is the additional return that investors demand for taking on higher levels of risk. It is the excess return required above the risk-free rate (typically the yield on long-term government bonds) to invest in riskier assets. So, when the Reserve Bank of New Zealand moves the official cash rate up, as we have seen in the past 24 months, this affects the required return on all asset classes, both debt and equities. The risk premium can vary depending on the specific asset and the perceived level of risk, but generally equity is considered riskier than debt.

Investors expect higher returns from riskier assets, such as equities, to compensate them for the additional risk they incur when investing. For example, equities are subject to market fluctuations, and their prices can be highly volatile. Equity holders are also the last “claim” on the assets of a business in the event of insolvency, making them more exposed to the company's bankruptcy. Finally, equity investments often require a longer time horizon for potential returns. Debt investors can expect interest payments almost immediately after buying the debt security; equity investors potentially lock in their capital for a considerable amount of time.

Rising interest rates means new debt issues will earn a higher rate of return. This higher return reduces the attractiveness of the returns from riskier assets like equities. The shrinking risk/return gap means equity prices usually become cheaper (falling share prices and stock markets) to restore the risk premium to debt which otherwise would have shrunk, making equities less attractive. The share price has to fall to attract new equity investors.

So, what is the “right” risk premium for investors? It is not just the gross return to the investor that matters, but the return for the risk taken. Modestly higher returns might have come with significantly higher risk and the investor wasn’t necessarily rewarded for taking on that higher risk.

Risk-adjusted returns

Calculating risk-adjusted returns is essential when evaluating an investment return as it provides a more comprehensive assessment of an investment’s performance by accounting for the associated risk. Risk-adjusted returns allow investors to compare investments across different asset classes and helps investors make informed decisions. Professional investors such as portfolio managers are often judged by their ability to generate returns relative to the risk they take across their portfolio.

The most commonly used method to calculate risk-adjusted returns is the Sharpe Ratio, but other metrics exist, like the Information Ratio.

The Sharpe Ratio considers the excess return of an investment (return above a risk-free rate) divided by its standard deviation, which measures the investment’s volatility. This ratio quantifies the return generated per unit of risk. A higher Sharpe Ratio implies a better risk-adjusted return, as it indicates a higher return for the same level of risk or lower risk for the same level of return.

Assessing risk-adjusted returns allows investors to balance their portfolios to achieve their risk-reward profile and avoid investments that might be too volatile for their risk tolerance. Those investors with long-term financial goals also benefit from risk-adjusted returns as they can optimise their investment strategies for sustained growth while managing long-term risk.

For an investor, understanding the different risk profiles in commonly held securities, like debt and equities, is important. While retail investors may not always go to the lengths of calculating the Sharpe Ratio on their investments, understanding the concept of risk-adjusted returns, and ensuring you are getting reasonable returns for the risk taken, is an important part of any investment strategy.

Understanding risk-adjusted returns and the volatility of different asset classes enables investors to make more informed choices, manage risk effectively, and assess investment performance more accurately, all of which are paramount for achieving financial success in the complex world of investing.