Are Investors Compensated For Risks They Undertake?

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by: Gene Balas, CFA

Summary

The compensation one gets from investing in longer term bonds, the term premium, is now negative.

Credit spreads are the tightest in years, meaning less compensation from investing in high yield.

Meanwhile, stocks are richly valued compared to history.

Can bonds be a buffer to stocks if markets take a tumble or, instead, could possibly rising bond yields cause a market selloff?

We all know investors are starved for yield. Some investors have invested further out on the yield curve; others have gone into lower-tiered credits. What both of these actions have done is to increase bond prices and depress yields such that, well, there's no longer much compensation for either interest rate risk or credit risk. Still other investors have focused their portfolios on stocks, some of which may pay dividends. Our question is whether investors are compensated for the risks they undertake in seeking more return potential.

Are investors compensated for interest rate risk?

Let's look at interest rate risk first. If you buy a longer term bond, you want to be compensated for the fact that longer term bonds fluctuate more in price than shorter term bonds in response to changes in interest rates. If you want to invest in a 10-year bond, you could alternatively invest in a series of shorter term instruments, reinvesting each sequence into another short term instrument for the 10-year horizon. The difference of investing in the single longer term bond instead of a series of short-term instruments is the term premium. Usually, it is positive, and since 1961, it has averaged 1.64%, according to the New York Fed.

It is now negative, at -0.32%, according to Bloomberg data. This makes conceptual sense, because the 10-year Treasury currently yields roughly 2.2% or so, according to Bloomberg data, whereas Fed officials view the Federal funds rate to eventually settle in a rough range of 2.75% to 3.0% in the long run (each Fed official submits their own view). In other words, 10-year Treasuries currently yield less than the rate where Fed officials believe short-term rates will eventually be.

Now, changes in the term premium have been neatly negatively correlated with bond prices, using the 10-Year Treasury term premium compared to the iShares Core U.S. Aggregate Bond ETF. Because the term premium has risen and fallen more or less in relationship to longer term rate movements in the current environment, it isn't surprising that longer term, higher quality bonds would move inversely to the term premium. If the term premium rises from its current -0.32% to anywhere near where it used to be, it stands to reason that, yes, bond prices could fall.

Are investors compensated for taking on credit risk?

So, the bottom line to this exercise is that if one isn't compensated for investing further out on the yield curve, what about taking on more credit risk? After all, economists' recession probabilities are not all that elevated, at 16% over the next 12 months, according to a Wall Street Journal survey of economists. In the last debt ceiling crisis in 2011, by comparison, that probability was over 30%. So, that would seem to argue for taking more credit risk, wouldn't it?

Well, you may be right, but there is a reason that "risk" is part of the term, "credit risk." Disasters, large or small, can come out of anywhere, or at least the occasional hiccup. The question is, whether one is compensated for taking those risks. Consider the graph below showing the difference in yield of high yield bonds vs. Treasuries. The bigger this amount, the more yield premium one would receive - and the more compensation one gets for taking credit risk.

Right now, investors aren't being highly compensated for taking credit risk. Investors also don't necessarily have a great deal of foresight. Take a look at the graph, homing in on how tight spreads were in 2007, and then, the recession hit. As credit spreads spiked mere months after being so tight, when investors were arguably so confident good times would continue, high yield bond prices plunged. Better to have bought when one would have at least gotten a bit more yield premium for taking on this risk.

Examining cause and effect

Consider one argument for holding longer term Treasuries - that of a flight to quality scenario when anxious investors flee into the safe haven of Treasuries. Perhaps the market takes a tumble and investors want to move their cash somewhere safe, for example. That would seemingly be a good argument for investing in longer term Treasuries, right?

However, what if we flip around cause and effect? What if rising bond yields were the culprit behind a drop in stock prices? I'll stay away from making forecasts, but consider that low interest rates had compelled investors to take on more risk in their portfolios to generate returns. If rates are higher, bonds may eventually become more attractive and siphon off funds that are now in stocks. In that case, bonds might not be a buffer to stocks if markets take a tumble; instead, could possibly rising bond yields cause a market selloff?

Stocks are richly valued

This is especially the case given that stocks are richly valued. Consider the graph below of the comparison of stock prices to company earnings and stock prices to the net worth of companies. The price/earnings and price/book value ratios are the highest in years (except for during the recession, when many companies' earnings took a hit). In parallel fashion to the issues we examined in the bond market, high valuations may mean that investors could receive less compensation for risks of investing in stocks.

Conclusion

Considering all of the above, the point of this exercise is not at all to make forecasts: I find they usually turn out to be wrong. Rather, it is simply to ask a rhetorical question: Are investors being compensated for the risks they undertake? This should not necessarily deter investors from following the long-term strategy that meets their objectives; quite the contrary, timing the markets is fraught with difficulty and error. After all, knowing when to get back in is especially difficult as well, for example. However, perhaps the greatest takeaway is that, even if risks do not materialize, one may need to become accustomed to returns that don't quite live up to what investors have become accustomed in years past.

And, that may mean doing absolutely nothing.

Disclaimer

Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.

© 2016 United Capital Financial Advisers, LLC. All Rights Reserved

www.unitedcp.com

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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