Zaks Investment Advisory Service

Difficult Start for 2008: Risk Premium Takes Toll

The first two months of 2008 were quite disappointing for investors. The S&P 500 index fell by more than eight percent. Some commentators blame the impending recession. Whether we’ll end up in a recession or not is academic: clearly, the economy is slowing down. Is the drop in corporate profits to blame? Sergey Zaks analyzes the changes in interest rates since the beginning of the credit crisis and comes to the conclusion that the main culprit is Risk Premium. See the discussion here.

Good News: Low Inflation Expectations

Inflation expectations are well contained. Despite a number of negative signs, the market still believes that inflation will remain subdued. The chart below represents the yield spread between the 10-Year Treasury note and Treasury Inflation-Protected Securities with 10-year maturity. Even though there are some known problems with this indicator, such as the relatively low liquidity of TIPS, we still believe that this is the best available indicator of inflation expectations.

Source: Federal Reserve Statistical Release, February 29, 2008

As we can see, even though inflation expectations did perk up a bit in the last 30 days, they are still well within the four-year band of 2.20 to 2.80.

Bad News: Risk Premium Rising

The following chart displays yields to maturity on a 5-Year T-note and High-Yield bonds since about a month before the start of the credit crisis. While T-note yields have been going down, yields on High-Yield bonds have risen sharply.

Source: Federal Reserve Statistical Release, February 29, 2008, FINRA-Bloomberg Active US Corporate Bond Indices

Risk Premium Grows

Risk premium has not only grown on High-Yield (Junk) bonds. Quite respectable Baa bonds have also seen higher risk premiums.

Source: Federal Reserve Statistical Release, February 29, 2008, FINRA-Bloomberg Active US Corporate Bond Indices

High Risk Premium Affects Stock Prices

High Risk premium means higher discount rates, which the market uses to implicitly evaluate the fair value of securities. The following chart depicts Risk premium on High-Yield bonds vs. the S&P 500 index since the start of the credit crisis. We can see that they are practically mirror images of each other.

Source: Federal Reserve Statistical Release, February 29, 2008, FINRA-Bloomberg Active US Corporate Bond Indices, Standard& Poor’s

Subprime Mortgages: Still a Major Problem

The crisis with mortgage-backed securities precipitated the crisis on all credit markets. How bad are things on the mortgage-backed front? Pretty bad, as we can see. Markit Group, a private company headquartered in London, publishes data on several credit derivatives. The data comes from 85 dealing firms, which include all the major international banks. The company created several indices, one of which is called ABX. It serves as an indicator of how risky the market perceives the different mortgage-backed securities to be. The first chart, below, represents the index related to AAA and AA mortgage-backed bonds, that is, the bonds of the highest quality. As we can see, even in September 2007, the AAA bond was perceived to be as practically risk-free (the index was almost at 100). It has lost almost 50% of its values since. AA bonds lost even more.

Source: Markit Group Limited, by permission

The lower quality A mortgage-backed bonds suffered even worse, going from approximately 70 to 17. To put it into perspective: today, the market perceives a AA bond as being much riskier than what a BBB, the lowest-quality bond, was in September of 2007.

Source: Markit Group Limited, by permission

These graphs vividly demonstrate the crisis raging on the credit markets. All financial markets, including the stock market, will not recover unless this crisis is resolved. As disappointing as these results are, we believe this picture has a silver lining. Sustained and energetic cuts by the Federal Reserve could restore stability in the credit markets, decrease risk premia and subsequently lift stock prices. Considering that inflation expectations are still well contained, we expect the Federal Reserve to follow this course.