Investors Want More Rewards for Taking Risk
Modern Portfolio Theory is based on the premise that investors require higher returns (a risk premium) in exchange for taking on added risk. The risk premium can take on many forms, including:
- The higher interest rate normally received on longer-term bonds in exchange for tying up the money for a longer period
- Higher returns on corporate bonds than on government bonds
- The growth potential (in addition to earnings yield) available on stocks
Recently investors have asked for less return for most of these risk measures than they have in the past. The inverted yield curve is a case in point: instead of higher returns for tying up money for a longer term, investors get less.
Another example is the difference in returns between investment grade corporate bonds and government bonds – in particular the difference in yield (yield spread) between Baa- rated bonds and Treasuries (see graph).
The higher the spread, the more investors demand as compensation for taking on the risk of corporate bonds. What’s more, as the labels show, the credit spread serves as a useful proxy for how much risk investors are willing to accept for other assets (such as equities) as well. When the spread started to widen in 2000, it marked the peak for equity prices. When the spread began to narrow in early 2003 stocks had bottomed.
Right now investors have been accepting less compensation for credit risk than they did at the peak of the Internet bubble (though other periods in history have been lower still.) But the spread has begun to widen, and has broken out of the downward trend in which it had dwelled since 2003. How much farther it will go is anyone’s guess. But the more investors demand in exchange for risk, the lower asset prices must fall in order to offer adequate compensation.
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