As risk increases, spreads widen

In October 2006, I attended a talk by Vanderbilt Treasurer Bill Spitz showing that risk premia (the extra return you receive for investing in risky assets) were very small. The differences between returns on stocks vs. bonds, low vs. high quality stocks (low debt, high and stable profit margins), and emerging market debt vs. US debt were at all time lows.

Small spreads between risky and less risky assets mean either that the world had gotten less risky, or that investors were ignoring risk in search of higher returns. Spitz thought it was the latter which motivated his investment advice:

• Avoid Riskier assets
  
• Stick with quality
• Be skeptical of the rush to alternatives
• Moderate return expectations
  
• Borrow now if you are a marginal credit
  

Well it looks like the risk has returned, or that investors are no longer ignoring it. The Volatility Index (invented by colleague Bob Whaley) which measures the implicit risk in options prices (the higher the options price, the bigger implied risk) has doubled since Spitz's talk a year ago. The expected annual change in stock prices is now 23%.


As this risk is recognized by investors and "priced" by the market, one would expect spreads to widen. For example, the spread between jumbo loans (bigger and therefore more risky) and "conforming" home loans has jumped by about 100 basis points (1%) in the last two weeks (article).

How many of us would have been able to foresee these changes a year ago? And what advice would you give now?