Equities should give a risk
premium over bonds and cash in the long run due to a combination of what they mean for the issuer and what they mean for the buyer.
Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5 % risk
premium over bonds.
I re-ran the analysis that Michael and I did in our initial article, but I switched to the new capital market assumptions I use which allow for increasing bond yields over time while keeping a fixed average equity
premium over bonds.
Hypothesis: The higher the CAPE10 risk
premium over bonds, the faster the market will rise.
Doing a very rough average, and considering that the NASDAQ was in a boom period for most of the study period, I am comfortable with a reduction in the US equity risk
premium over bonds down to 1 - 2 % on average, and over cash to 3 - 4 % on average.
I am not a backer of the idea that the equity return
premium over bonds is big, but I do back the idea that it is positive.
Stocks wouldn't offer a risk
premium over bonds if they didn't have these periodic large selloffs.
Also, like the Fortune column points out, the thesis that interest rates will inevitably rise, so bonds are a bad idea but stocks are now undervalued because of wide
premiums over bonds is seriously flawed because if bond yields rise, it will be bad for bonds but the equity premium will drop as well, so it may not be necessarily good for stocks.
A premium bond has a coupon rate higher than the prevailing market interest rate, but with the added
premium over the bond's par value, the effective interest rate on a premium bond is actually equal to the lower, prevailing market interest rate.
Not exact matches
For, with long - term taxable
bonds yielding 5 percent and long - term tax - exempt
bonds 3 percent, a business operation that could utilize equity capital at 10 percent clearly was worth some
premium to investors
over the equity capital employed.
This has been the case historically, as stocks have earned a 5 - 6 %
premium over high quality
bonds going back a hundred years or so.
This data goes through year - end 2013, when the risk
premiums for stocks
over long - term
bonds in the most recent 10, 20 and 30 year periods were 1.5 %, 2.4 % and 1.8 %, respectively.
The incredible performance in
bonds has transformed the risk
premium over this period.
A quick glance at the graph suggests that the wealth transfer from
bond to stock investors has declined
over the last 50 years and may now represent a much more modest
premium for long - term stock investors.
One is legitimate — every year in which short - term interest rates are expected to be zero instead of say, a typical 4 %, should reasonably warrant a 4 % valuation
premium in stocks and
bonds,
over and above run - of - the - mill historical norms (one can demonstrate this using any discounted cash flow approach).
(This rate is the difference between the yield on
bonds that include an inflation risk
premium and those on inflation protected
bonds; once you «net out» the latter, what's left
over is inflation expectations.)
Specifically, analysts argue that the «equity risk
premium» — the expected return of stocks
over and above that of Treasury
bonds — is actually quite satisfactory at present.
Also, the yield on the 10 - year Treasury note was
over 6 % 15 years ago versus roughly 2 % today, making the risk
premium of stocks versus
bonds much higher today than it was then.
What about the argument that the equity - risk
premium (the
premium that investors demand
over risk - free assets such as government
bonds) has fallen close to zero because of greater economic stability?
The
bond maturity
premium over bills was just 0.7 % in the U.S. and 0.5 % worldwide, small with respect to the much higher risk (variability of returns).
Chapter 12 — The Equity Risk
Premium examines the excess returns of stocks
over bills and
bonds (equity risk
premium) in 16 countries during 1900 to 2000.
Over the entire century, high - grade corporate
bonds offered an incremental 0.5 % of compounded return as a default risk
premium.
This is inaccurate, because there are other factors which combine with credit risk to make up the «spread
premium» that other types of
bonds have
over treasuries.
The term
premium is the extra compensations investors require for the risk of holding a long - term treasury
bond versus a sequence of short - term treasury bills
over the same period.
«Finally, in circumstances where a major central bank is continuing to expand its balance sheet or maintaining a large balance sheet
over a sustained period, this policy would likely exert downward pressure on term
premiums around the globe, especially in those foreign economies whose
bonds were perceived as close substitutes.
In the article in Rockland Voice to which Chairman Wolfe took umbrage it was written: The Democratic Chairman of the County Legislature Alden Wolfe appears to be playing political games
over an $ 11 million
premium that the County earned of its deficit financing
bond.
Many believe this dynamic can go on, since rates are probably going to remain low, creating a still high «equity risk
premium» — the likely return from stocks
over bonds.
CFOs, meanwhile, estimate the
premium to be 5.6 %
over T - bills (U.S. government debt obligations with maturities of less than one year) and 3.8 %
over T -
bonds (maturities of greater than ten years).
So, unless something truly catastrophic happens (like the US government defaulting on its
bonds) or people in the company break the regulations (which would invovle all kinds of serious crimes and require complicity or complete failure of the auditors), your
premiums and the contractual obligation to you would still be there, and would be absorbed by a different insurance company that takes
over the defunct company's business.
· Shares and shibboleths http://t.co/CspyJCNX The equity
premium over a diversified portfolio of investment grade
bonds is ~ 1 % / yr IMO $ $ Mar 19, 2012
A large portion of your
premiums payments will be invested in the insurance company's investment fund in whatever asset class you prefer (stocks,
bonds, mutual funds, money market funds, etc.)
Over time, this has the chance to generate a much larger cash value in your insurance account than a traditional whole life policy does.
In order to lure investors away from Treasuries to buy mortgage
bonds lenders have to offer a
premium (AKA «spread»)
over what can be earned on the «risk free» Treasury.
Also, the yield on the 10 - year Treasury note was
over 6 % 15 years ago versus roughly 2 % today, making the risk
premium of stocks versus
bonds much higher today than it was then.
This notion is further supported by the inherent risk
premium for stocks
over bonds because stockholders are behind bondholders in the first lien on a company's resources in bankruptcy.
Companies with lower credit risk (higher credit rating) often enjoy a competitive advantage
over their peers because higher rated companies can sell their
bonds at a
premium to lesser rated
bonds.
But relative risk
premiums still favor stocks
over bonds.
I am looking at canadian
bonds and all of them are selling at
premium over par.
If an institution sells a
bond with a $ 100
premium and a 10 - year maturity to a buyer, the institution is agreeing to pay back the $ 100 to the buyer at the end of the 10 - year period as well as regular interest payments
over the course of the intervening period.
The
premium should be high enough to offset any expected changes in inflation
over the life of a loan or
bond.
When
bonds are purchased at a
premium (greater than $ 1,000 per
bond), a prorated portion of the amount
over par can be deducted yearly on the purchaser's tax return.
The average junk
bond risk
premium is 4.55 percentage points
over comparable Treasury yields, and this has helped buffer high yields somewhat from rising Treasury rates.
The total dollar amount of interest
over the life of the
bonds is adjusted by the amount of
premium or discount bid, and then reduced to an average annual rate.
While Muhlenkamp reminds us that this volatility is less important as investors lengthen their time horizon, stock investors still demand
premium return
over bonds as compensation for the increased volatility and risk inherent in stocks.
Given that those
bonds yield a 1.5 percentage point
premium over government
bonds (which have a default risk close to zero), a corporate
bond investor is likely to be left with a one percentage point advantage
over government
bonds after accounting for the risk of loss.
To offset those potential losses, investors are demanding a 5.5 percentage point
premium over government
bonds to buy these high - risk
bonds.
It will never be that tidy because interest rates change constantly, but the key point is that any
bond ETF filled with high - coupon
premium bonds should be expected to fall in price
over time.
If a less specific group of
bonds can be delivered to create a new unit, i.e., the
bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option - adjusted spread / yield, etc., then arbitrage can proceed more rapidly, and
premiums over NAV should be smaller.
As always, one last point to remember is that one of the advantages of TIPS
over nominal
bonds is that you can take maturity risk with TIPS and earn the term
premium without taking inflation risk.
The amount of coupon payments
over the effective interest expense or interest income is actually the
premium of the
bond, which is amortized
over the term of the
bond to reduce the value of the
bond to its par value at maturity for
bond repayment.
Of course, the
bond interest might not quite be enough to cover the traditional LTC
premiums right now (and therefore deplete principal slightly), but it will be more than enough once rates rise, which again seems like a reasonable «bet» for someone who still has a 10 - 20 + year time horizon for long - term care and retirement needs (and
over that time horizon, the client could have generated an amount equal to the hybrid life / LTC death benefit just with normal growth!).