Gauging the Market's Appetite for Risk in the Bond Market

by: Eddy Elfenbein

A good way of gauging the market’s appetite for risk is by looking at the difference in bond yields of high-grade and lower-grade bonds. Here’s a look at AAA and BBB bond yields since 1962:

Notice how the BBB yields are always just a bit more. But that gap varies over time. Here’s a closer look since at the same graph, but since 2003:

Now, here's a look at the risk premium for BBB bonds. By rate premium, I mean the difference between the AAA and BBB bond yields. For example, if AAA bonds are going for 10% and the BBBs are going for 12%, the premium would be 20%.

As you can see, the risk premium seems to bounce between two points. It's either less than 10%, or more than 20%. That's a very rough generalization but there's not much in between.

When the premium rises above 20%, that means that investors are demanding more money to take on greater risk. The high premium signals fear with investors and generally coincides, and often causes, a recession.

The risk premium shot over 20% shortly after 9/11 and eventually got as high as 25% in mid-2003. However, the premium gradually drifted lower although it never fell below 11%. Just recently, the premium jumped over 20% for the first time in over four years.