The spread between the return on 10-year Treasuries and Baa-rated corporate bonds was 336 basis points last week. In historical terms, that is very high. In fact, the only times in the last 50 years that it was higher were the trough of the tech wreck and the 1982 recession/stagflation busting cycle.

High credit spreads make it harder for corporations to borrow and invest. As spreads widen, the economy tends to slow.

For investors, however, high spreads represent additional potential returns for a given unit of risk-taking. Peak levels of risk premia typically precede strong returns on risky assets – even if the strong returns are short-lived, as was the case in 2003.

Spreads have hooked down slightly as the credit woes that peaked following the Bear Stearns (BSC) debacle may finally be stabilizing. Time will tell whether that was “the” peak or whether the current easing is simply a lull.

Regular readers know I follow the spread between Baa-rated bonds and Treasuries to get a feel for how much they are willing to accept risk.

Last week, as the market rallied on the initial news of the JP Morgan (JPM - Annual Report) and Fed-led rescue of Bear Stearns (BSC) I said “The big questions are whether, how much, and how quickly the spreads will begin to narrow again. That will be the real signal from bondholders that the worst is behind us from the current crisis.”

Instead, credit spreads continued to widen. They averaged 343 basis points last week, up from 340 in the prior week.

It remains a double-edged sword. As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.

Regular readers know I follow the spread between Baa-rated bonds and Treasuries to get a feel for how much they are willing to accept risk.

Right now, it is not much.

Last week the spread widened to 340 basis points, a level seldom seen over the last 50 years.

Of course, we knew that already. The big questions are whether, how much, and how quickly the spreads will begin to narrow again. That will be the real signal from bondholders that the worst is behind us from the current crisis.

It is something of a double-edged sword. As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.

According to the Federal Reserve, the spread between the interest rate paid on Baa-rated corporate bonds and the 10-year Treasury continued to widen last week, to 311 basis points. The spread has seldom stayed above 300 basis points for very long, going back to 1962.

Over the last 10 years, the Internet bust caused a couple of such spikes.

As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.

I follow the spread between BBB (the highest investment grade) corporate debt and Treasuries as a gauge of overall investor willingness or unwillingness to accept risk. Lately, investors have been less and less willing to accept risk, plowing money into Treasury bonds and lowering their yield.

The spread is now 296 basis points, which is close enough to my 3% trigger to call this an “official” crisis. Such events tend to happen only once or twice per decade. As a general rule, they have typically signaled good times to be in risky assets such as stocks.

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.

The current spread is nearly as high as that of the 1998 Russia/LTCM crisis. The truly big investing opportunities (the telecom bust, the 1987 crash) usually offer spreads above 300 basis points.

The risk premium between investment grade corporate bonds has widened, resulting in the largest rewards for those willing to accept default risk since mid-2003. The spread is nearly as wide as it was during the 1998 Russia/LTCM crisis.

That is not to say it is a good time to buy risky assets, but it does indicate that the likely payoff for doing so is higher than normal.

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.

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.

The risk premium for corporate bonds (the difference in rates between treasuries and Baa-rated corporates) is edging back down after its mortgage meltdown-induced mini-spike. It seems the Fed’s rate cuts are carrying through to the general market.

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.

Last week I talked about how 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. I said it would be interesting to see whether the Fed’s rate cuts affect long-term rates. The economy could actually do worse following the cuts if the spread widens further.

So far, the spread has narrowed just a smidge, to 2.08 in the week ended 9/21 compared to the 9/14 week.

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.