HomeSystematic ValueThe rise in risk spreads

The rise in risk spreads


A risk spread is a premium for bearing economic risk of an investment, paid over and above the short-term real interest rate. Over the past 30 years, risk spreads in the U.S. have increased significantly and consistently: while real interest rates on ‘safe’ bonds and deposits have collapsed, returns on private capital have remained roughly stable. Macroeconomic research suggests that this secular rise in risk spreads owes mainly to higher risk premia charged by financial markets and higher monopolistic rents extracted by companies. The strategic implication for rational investors would be to receive risk spreads, since they seem to pay an elevated reward for bearing economic uncertainty that is augmented by payoffs for the market power of companies.

The below summary is based on:
Farhi, Emmanuel and François Gourio (2019), “What is Driving the Return Spread Between ‘Safe’ and ‘Risky’ Assets?”

Strategies Emphasis and cursive text have been added.
The post ties in with the SRSV summary on implicit subsidies.

What are risk spreads?

In principle, risk spreads denote the difference between expected returns on assets with economic uncertainty, such as equity and credit, and holding period returns on assets that are conventionally labeled as ‘safe’, such as short-term government bonds or deposits with low default probability. Conceptually these spreads are an equilibrium premium for bearing real economic risk. In the below-quoted research the risk spread is approximated by the difference between ex-post returns on private capital and a real short-term (presumed) risk-free interest rate.

The secular rise in risk spreads

Real interest rates on U.S. government bonds have declined persistently since the 1980s…More broadly, interest rates on other safe assets, such as highly rated corporations, have also declined…In stark contrast, the return on more risky assets does not appear to have declined significantly. For instance, the return on private capital, i.e., profit made per unit invested for the economy as a whole, appears to have remained roughly stable…[As a result,] the difference, or spread, between the returns on risky assets and the returns on safe assets, has increased.

Explaining the rise in risk spreads

“One popular theory is that this reflects a higher desire to save related to an aging population and rising longevity. As the average worker in the U.S. and elsewhere gets older, they increase their savings rate to prepare for retirement. However, this theory cannot explain why the return on private capital has not fallen by the same amount.”

“Our framework builds on the standard neoclassical growth model, the backbone of modern macroeconomics, which is often used to describe the interactions of investment, output, capital, and labor…Our main innovation is to introduce risk in a tractable manner, which allows us to analyze the risk premium story…We can use this formula to infer the risk premium on private capital from the observed growth rate of gross domestic product (GDP), the safe interest rate, and the price–dividend ratio of the U.S. stock market…This model can be used to infer which of the causes accounts for the observed changes in the data— and, importantly, the lack of changes in some variables.”

“In theory, one would expect businesses to expand investment up to the point where the return on capital equals the safe interest rate. Low interest rates should have stimulated investment, leading to an economic expansion until the return on capital is as low as the safe interest rate. This expansion…did not happen.”

“Our approach uses macroeconomic and financial data jointly to disentangle the rents (market power), risk premium, and technology stories… We found that risk premiums and rents played the most significant roles in explaining trends in asset returns, savings, and investment over the past 30 years.”

The rents storyFirms are underinvesting because of limited competition, i.e., monopolistic behavior. Facing limited competition, firms prefer to increase prices, which reduces demand for their product and, hence, the need for output; this in turn limits the need for new production capacity…This story has received significant support in recent studies…If competition between firms were perfect…user cost of capital…would equal the return on private capital. But if there is market power, the user cost will be lower than the return on capital. We can deduce the market power (or monopoly power) necessary to be consistent with the observed return on capital.”

The risk premium story…Investors have become more concerned about risk and, therefore, their preference for the safety of U.S. government bonds over investment in private capital has increased. Investing in private capital is undoubtedly riskier than investing in U.S. government bonds, leading investors to require a higher return to invest in private capital—a risk premium wedge. If investors perceive risk is increasing or become more risk averse, this wedge increases.”

The technology story…Technological change is affecting the return on capital—e.g., through changes in the cost of buying new capital goods, changes in physical depreciation, or changes in the production process. For instance, a large share of capital now takes the form of information technology (hardware or software), which is becoming cheaper over time and tends to depreciate quickly. These trends tend to reduce the return on capital. “

Empirical evidence

“Our main finding, summarized in [the figure below], is that the rents and risk premium stories are the most important in helping us to understand the return spread trends of the past 30 years. The top panel depicts the raw data: the spread between the rate of return on private capital and the safe (risk-free) interest rate. The bottom panel depicts the three components of the spread corresponding to technology, the risk premium, and rents, as inferred from our accounting framework. We find that the technology component is stable and, hence, does not account for the increase in the return spread that we observe during this period.”

“Both the risk premium and rents stories play significant and roughly equal roles in accounting for the increase in the spread during the past 30 years…We find that the spread increases by about 4 percentage points…between  the 1984–2000 and 2001–16 periods…with roughly half due to rising rents and half due to rising risk.”

“These results are consistent with a broad set of results [of other research papers] that also show the risk premium has increased… Perceived risk has likely been higher after the sequences of financial crises in emerging markets in the 1990s and in developed markets in the 2000s. Effective risk aversion may also be higher due to an aging population, heightened precautionary behavior of emerging market investors, or changes in regulation.”

N.B.: The preference for safe assets over the past decade has been reinforced by increased collateralization (view post here) and regulatory reforms in the financial sector, such as Solvency II (view post here) and Basel III.

Ralph Sueppel is managing director for research and trading strategies at Macrosynergy. He has worked in economics and finance since the early 1990s for investment banks, the European Central Bank, and leading hedge funds.