Monday, September 20, 2010

Are the bond markets ignoring risk?

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
Today the WSJ had a front page article about the low spreads in the bond market.  Made it seem like deja vu all over again:
The rally in the corporate-bond market and a steady supply of easy money courtesy of the Federal Reserve are encouraging investors to take more risks. And Wall Street bankers and companies are taking advantage where they can.

The Financial Times ran a similar article: "Junk bond prices hit pre-crisis levels"
Strong investor demand for junk bonds has pushed the average price on such corporate debt to its highest level since June 2007, when companies could borrow with ease at the height of the credit boom.

We have blogged about whether high bond prices (low yields) are a bubble, or driven by fundamentals.

Of course, if I really knew, wouldn't I just invest myself instead of blogging about it?

1 comment:

  1. Fluctuations in prices are always more of a function of investor behavior (bid/ask) - whether you call it a bubble or a smart trend. Fluctuations are not as much a function of fundamentals because fundamentals have been historically used to set prices based on our (now outdated) CAPM model but then market forces largely take over the 'reasons' for changes in price. Another way of asking your question would be: is the corporate bond market rally justified based on the fundamentals? I would submit that enough people with enough money either think so or were convinced by brokers or have bought anyway on the calculation that high yield bonds were a good value given alternatives at the time. Either way, it's always about the yield. Are the fundamentals driving the bids which drive the pricing which drives the bubble? Why ask why?