Does Greater Risk Always Lead to a Bigger Payoff?

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

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.