Risk Premia Update
The risk premium for corporate bonds (the difference in rates between treasuries and Baa-rated corporates) has been rising in recent weeks, though not as much as I would have expected given the mortgage meltdown.
A lower spread is positive for the economy and for corporate earnings, as it means companies don’t have to pay as much (relative to riskless treasuries) to borrow money that can then be invested in profitable opportunities. In effect, it lowers the bar as to what makes for a worthwhile investment. A low spread has a mixed message for stock market investing - good for earnings/economy per above, but means investors are being paid less to take risks.
A few things are readily apparent - one being that spikes in the rate are often good times to buy equities. This is because the spikes mean compensation for risk taking is higher than normal. Witness the late 1998 Asian Contagion spike, as well as the October 2002 market low in the midst of corporate scandals and bankruptcy. It is also fairly obvious that there is a ways to go before the spike gets high enough to signal a contrarian buy.
From a longer-term perspective, the spread has been much lower, though it hasn’t stayed consistently below 150 basis points since 1982. The more modern norm is the 150-200 basis point range we recently broke out of. Above 250 is where it starts to get interesting for the contrarian play.
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