Risk Premiums and What They Mean for Your Portfolio
Given an ever-shifting market, it’s important to stay abreast of asset class expectations and how changes in market levels over time can help drive asset allocation decisions in an investment portfolio. In our first blog series on capital markets, we presented our forward-looking risk and return estimates. In this blog we will check current markets relative to our projections and illustrate how we use risk premiums to garner insights necessary for optimal portfolio recommendations. Keep reading to learn more about risk premiums, what they might mean for your portfolio and why now is a prudent time to take inventory of your asset allocation across your entire balance sheet.
Both stock and bond markets are at or near all-time highs but historically these markets have not been correlated like they are today. In fact, the S&P 500 Beta for the Barclays US Aggregate Bond Index is -0.03 which indicates virtually no relationship between the change in price between stocks and bonds and suggests that price correlations will likely diverge at some point in the future. Thus, the question is not whether stocks or bonds will go up or down but whether stocks are cheap relative to bonds; and other assets like real estate. In order to solve this riddle, we can utilize risk premiums in different markets to evaluate which may be over/under valued. This blog post will examine current risk premiums in the stock and bond market(s) to assess relative valuations between the two and garner investment insights.
Risk Premiums – What are they?
Risk premiums represent the price of risk in different markets and investors can use them as a gauge of relative risk. They also reflect fundamental judgement about how much risk we see in an economy/market and what price we attach to that risk. The price of risk influences our asset allocation decisions as well as security selection within each asset class. The following are some (not all) factors that influence risk premiums:
- Risk Aversion
- Consumption Preferences
- Economic Risk
- Liquidity and Fund Flows
- Catastrophic Risk
- Government Policy
- Monetary Policy
As seen in the list above, risk premiums are complex, and embedded in them is a significant amount of information. Fortunately, risk premiums can be extracted from market data which infers that the considerations above are baked in to prices. Utilizing market data allows investor’s to assess risk premiums relative to their own forward looking views and relative to other markets.
Before diving into the different risk premiums, it is important to lay the foundation for why looking at risk premiums matters. By comparing risk premiums, investors and practitioners can evaluate risk and returns on a relative basis and make investment decisions accordingly. The table below provides an overview of the relationship between different assessments of risk and the related market interpretation and investment action.
Table 1 – Risk Premium Assessments
Equity Risk Premium
The equity risk premium (ERP) represents the price of risk in equity markets and can be inferred as the expected excess return over the risk-free rate. For example, if the risk-free rate is 2% and equity markets are expected to earn 7% then the ERP is 5%. This risk premium is interpreted as the opportunity cost for investing in a market as well as the expectation of what that market will return, on average. Both considerations can be adjusted by volatility (standard deviation) to provide a risk adjusted comparison as well.
In our blog series on capital market projections, we forecasted US Large Cap Equity market returns of 6.33% over 10 years with volatility of 15.58%. If we utilize our current 10-year treasury yield of 1.64% we would derive an estimated ERP of 4.69%. However, in practice there are a variety of methods for utilizing market prices and other data to model and estimate the ERP. At Centura, we calculate the current ERP to be 5.65% which would imply that relative to our 10-year outlook, stocks are currently undervalued at today’s low interest rates and may represent an attractive long-term investment. With the ERP explained, we turn to the RP of debt (bond) markets, also known as Credit Risk Premium.
Credit Risk Premium
When it comes to evaluating the bond market, we typically look to the default spread between a bond and the risk-free alternative (e.g., Corporate bonds vs US treasuries) to estimate the credit risk premium (CRP). Default spreads are the market’s interpretation of credit risk premiums at different maturities, and the tighter spreads get the more overvalued the market becomes (see Table 1). Fortunately, the US Federal Reserve provides default spreads, and for Aaa and Baa corporate bonds relative to 10-year constant maturity treasuries (i.e., risk free rate) the current (as of September 2019) spreads are:
- Aaa Corporate Bond Yield vs 10 yr treasury (constant maturity): 1.30%
- Baa Corporate Bond Yield vs 10 yr treasury (constant maturity): 2.20%
At Centura, our capital markets projection for US Fixed Income is 3.49%, which versus the current 10-yr treasury yield of 1.64% represents a 10-year projected CRP of 1.85%. This implies that fixed income is priced efficiently with our long-term credit market forecasts.
Stocks vs Bonds
On a relative basis, at a blended CRP of 1.85% vs an ERP of 5.65%, bonds look expensive versus stocks. That said, at Centura we prefer to look at risk adjusted returns when comparing what it takes to earn that extra risk premium. For example, fixed income standard deviation is estimated to be 3.45% which when paired with a blended CRP of 1.85% begets a Sharpe Ratio of 0.54. Equity Market standard deviation is estimated to be 15.58% which when paired with an ERP of 5.65% equals a Sharpe Ratio of 0.36. Thus, on a risk adjusted basis bonds are more attractive than equities. So, what does all this mean?
In summary, at current market levels the equity risk premium (ERP) implies that equities are cheap relative to bonds. The ERP also implies that equities are cheap relative to our forward-looking capital market projections; whereas bonds look more efficiently priced based on our forward estimates. Thus, we are bullish on equities for the long term (i.e., 10+ years). While we are neutral on bonds, we recognize that they provide enhanced risk adjusted returns and can serve a vital role in portfolio management as they help steady returns. Additionally, they allow us to target specific risk/reward mandates.
At Centura, we construct portfolios of stocks, bonds and other alternative assets utilizing risk premiums to assess relative value between asset classes and intra asset class as well. Given the long bull run in risk assets over the past 10+ years, we at Centura feel that this is a prudent time to take inventory of holdings across your entire balance sheet to ensure your asset allocation is in line with your risk tolerance and portfolio objectives. If you self-direct your own portfolio, or are interested in a second opinion on your managed portfolio, contact Centura Wealth Advisory for a complimentary portfolio review.
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