On Corporate/Treasury Bond Spreads and Risk Premiums

Includes: IEF, SPY, TLH
by: William Trent, CFA

It seems like everywhere I turn, I hear about how the bond market is in control, and the stock market is just tagging along for the ride. And this is true, to the extent that stocks and bonds in general are falling in price (rising in yield).

But there is one aspect of the relationship I haven’t seen explored, which is that of the risk premium, or the extra amount investors want to be compensated in exchange for taking a certain risk. There are many risk premia, among them:

1. The higher rate normally required when tying up money for a longer period.
2. The higher rate for corporate bonds as opposed to treasuries, in compensation for the risk that the company defaults.
3. The risk premium (typically manifest as growth) investors receive for investing in stocks rather than bonds.

There are many more, but I’ll focus on these three basic ones. The first one in particular was nowhere to be found in recent months, because the yield curve was inverted. You got paid more to invest short-term than long-term. The rise in interest rates that has so spooked the market has merely flattened the curve. Interest rates could go significantly higher before this relationship could even be considered “normal.”

As interest rates for treasuries have risen, so too have those for corporate bonds - though by a bit less. Since March the yield on 10-year treasuries has risen from 4.53% to the current 5.02% - a total of 49 basis points. The Seasoned Baa corporate bond yield, according to the Federal Reserve, has risen 43 basis points from 6.19% to 6.62% during the same time period. The difference in rates, called the Baa/Treasury spread, is the risk premium investors require for accepting the risk of corporate default. It has fallen from 1.66% to 1.60%.

The current 1.6% spread is toward the low end of the historical range, unless you want to go back to the 1960’s. Even then, it is below average.

baa treasury spread

What does this have to do with equities? After all, Stock Market Beat's (the author's blog's) tagline is “Our beat: The Stock Market. Our job: Beat it.” It is fair to ask why I am spending so much time on interest rates. Well, for one thing the equity risk premium logically ought to fluctuate with the Baa/Treasury spread because riskier equities tend to have more corporate debt. And it turns out, the two are related.

Take a look at the major peaks and troughs on that yield spread chart. The highs (2002, late 1987, 1982 etc) tended to mark good times to buy stocks. The lows (the late 1990’s, the late 1970’s and 1973 among them) were often bad times to buy stocks.

It isn’t the level of interest rates, or of P/E ratios, that should concern investors but the potential changes in interest rates and P/E ratios. Right now investors are willing to accept smaller rewards for each unit of risk they will take. There is a limit to this willingness, and when it turns, investors will see how interest rates can really drive stock returns. I hope to have plenty of ammo available the next time the Baa/Treasury spread jumps above 3%, because I’m pretty sure that will be a good time to buy stocks.