The Disappearance Of The Equity Risk Premium

(The following information was provided by nationally recognized Jeremy Siegel.)

OCEAN CITY – A basic tenet of financial theory is that equities will outperform fixed-income investments — they must to compensate investors for additional risk. The difference between equity returns and risk-free rates — known as the equity risk premium — was almost 9% for most of the 20th century, as detailed by William Goetzmann and Roger Ibbotson’s 2005 study, History and the Equity Risk Premium.

Today that premium has disappeared. Bonds now offer equity-like returns.

Virtually all fixed-income spreads are at record levels. High-yield corporate bonds are trading at approximately 1,400 basis points above equivalent Treasury bonds. As we noted in an article several weeks ago, investment-grade corporate bonds are trading at spreads of approximately 500 basis points, more than five times their traditional level.

Mortgage-backed spreads are at record levels. A mortgage pass-through security with little exposure to bubble housing markets yields in the mid-teens.

Municipal bonds are perhaps the most extreme example of a market turned upside down. Their yields exceed those of equivalent-maturity taxable bonds by 100 or more basis points. On an after-tax basis, these spreads are even greater. Such numbers are unprecedented in the last 40 years.

Private equity companies use leveraged loans to finance the purchase of companies in which they invest. Today, many of these loans trade at 70 cents on the dollar, often with yields exceeding 20%.

Yields on Treasury securities have contracted amid a global flight to quality, with the US government markets being the safe haven of choice. But everywhere else you turn, investors are being compensated at record levels.

Moreover, this is not a fleeting opportunity. Most of these spreads have been at record levels for over a month, without any sign of receding.

Eventually — probably fairly quickly — opportunities in the fixed-income markets with such high spreads will disappear. Cash balances in money market funds are at record levels, and investors’ patience will soon waver with the temptation of equity-like returns for securities that are undeniably less risky.

Investment-grade and municipal bonds should be the first to attract capital flows. There is no logical explanation for the yields they offer today.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)