A reader emailed me saying “Could you send me an update on the risk premium vs. equity prices? I am quite intrigued by this subject in light of the current divergence in equity and bond prices.” Happy to oblige an interested reader, I also thought I should post an update for all to see.
Risk premia are the extra returns investors want to receive in exchange for taking risk. There are many types of risk premia, including:
- The higher return typically earned for tying up cash for longer periods
- The higher return on corporate (defaultable) bonds compared to treasury bonds
- The higher return on stocks than on bonds
Some of the risk premia are hard to measure, but based on observation I have noticed that many are correlated. Investors not wanting one type of risk often don’t want any kind of risk. As a result, I often take the pulse of risk tolerance by looking at the corporate/treasury risk premium, which is calculated on a daily, weekly and monthly basis by the Federal Reserve. (Specifically, I compare the Baa Corporate bond rate to the 10 year Treasury Constant Maturity.)
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.
Since higher risk (or the perception of higher risk) lowers the price investors are willing to pay, the lower prices in turn provide the higher expected return. Note from the above graph that the risk premium spiked in 1998 (Russia/Asian/LTCM crises), which was actually a good time to buy. The premium was remarkably low in early 2000, a signal that insufficient risk was reflected in market prices. And the high premium in early 2003 marked the end of the post-bubble bust.
This summer the subprime crisis has hurt markets and boosted the premium investors require for risk to nearly the levels of the 1998 crises. The higher risk premia may indicate an opportunity to buy. Before jumping in, however, consider the longer-term history.
Since 1970, the risk premia has ranged from 1.5% to 2.5% with the exception of a few brief occurrences. Those occurrences seem to have been the better buy or sell opportunities – and the higher the spike, the better the time to buy. The latest instance has not yet broken the 2.5% barrier (though it is close) and is still some way from the 3.0% that characterized market troughs in 1974, 1982, 1987 and 2003.
It may come down to how much of a premium a given investor requires, and whether the investor wants to wait for the once-a-decade best opportunity or take smaller opportunities when they arise, knowing that they may still be in for some short-term downside.