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Too Much Risk for Too Little Yield


Investors are buying risky assets like corporate bonds at only a slight discount to non-risky asset like treasuries.


After reading the comment in Professor Bennet Sedacca's article, "I have never seen, relative to an economic backdrop like we have now, so little value in corporates, agencies, mortgages, etc." prompted me to write this.

What Bennet means by value is that investors are buying risky assets like corporate bonds at only a slight discount to non-risky asset like treasuries. They are willing to incur the risk of default, which should be higher for a company than for the U.S. government, for only a very small increment in yield. Bennet is describing an investor who is willing to take on too much risk for too little yield.

We can say this about many; the relative value of all risky assets to non-risky ones: stocks over bonds, real-estate over stocks, etc.

This is a phenomenon directly born of government policy, central bank intervention.

All central banks around the world have purposely driven real interest rates to zero or even below. Money is free. This means the worst of the worst, those willing to speculate and go bankrupt if necessary are free to buy risky assets. This forces risk premiums lower and lower. Even relatively conservative investors feel the pinch, the pressure to go out on the risk curve to just make a little money.

And the central banks want this. They have actually targeted lower volatility to encourage investors to take risk that they don't really see. Not until volatility rises does risk become apparent. So they are doing everything they can to keep volatility low and investors taking risk.

What happens if investors decide to take less risk? Heavens forbid they actually want to save money and not take on more debt. That would reduce risk and reduce liquidity. Volatility would go up and it would feed on itself. The credit bubble that has driven nominal asset prices to these levels (risky assets) would begin to unwind and the opposite would occur.

It is all about liquidity. Risk premiums are the largest variable in driving liquidity. People will be very surprised at how fast people want to reduce risk when they decide to. A very gradual and incremental process that has reduced risk premiums over the last several years can reverse quickly.

Central banks are doing everything they can to avoid this. Credit is being offered (money supply is high); will the market continue to keep taking it? My firm's work is showing the market on the margin is taking that credit less and less and it is going to the more and more speculative.

Hedge funds, mutual funds, and even pensions are taking the risk for the investor more than ever. These are in general managers that are once removed from the consequences of risk so they take more than the actual owner of the money would.

But that doesn't change the fact that markets do work and will eventually arrive at the right risk premium.

Bennet is saying that it is not there, not by a long shot. I agree.

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No positions in stocks mentioned.

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