For investors seeking value, understanding the ripple effects of policy on risk premia is essential to figuring out where to look for value and how to take advantage of the shifting tides.
Value investors have basic goals: Buy assets when underpriced, sell them when overpriced. To figure out which is which, they traditionally rely on hard economic data. Whatever part of the asset price falls outside of the data is known as the risk premium.
Simply stated: The risk premium is what an investor demands on top of an asset’s fundamental economic value, compared with holding a similar asset that poses less or no risk.
In the aftermath of the Financial Crisis, we have been living in the age of risk premia. That’s because central bank policies, rather than economic fundamentals, have often become the main driver of asset valuations. For investors seeking value, understanding the ripple effects of policy on risk premia is essential to figuring out where to look for value and how to take advantage of the shifting tides.
Central bank policies have essentially tried to reflate hard-hit asset prices—through regulatory changes, communications strategies, or outright asset purchases—by reducing the risk premia for certain assets. Sometimes, every tool in the box comes into play to stabilize markets and shore up confidence.
When asset prices no longer seem to reflect the fundamentals but, instead, go where policymakers are nudging them, valuations become skewed. Adjusting to this new environment is a challenge, but investors have had to figure out how to weigh new risk premia in their valuations.
One method is to size up term premia for long-term government bonds, considered risk-free and the safest of asset classes. Term premia represent the additional yield that investors demand to hold a long-term government bond instead of a series of shorter-term bonds. Because the risk is the same, the premium is purely based on the time frame.
Traditionally, the longer you’re willing to hold a government bond, the higher the yield. But term premia can be extremely low, or even negative. That’s exactly what happened in the US, when the Federal Reserve adopted quantitative easing (QE), a program to buy back Treasuries that was designed to drive term premia so low that investors would rebalance their assets away from risk-free government bonds into higher-yielding, riskier assets. The Fed’s QE policy succeeded, easing financial conditions, reflating assets and spurring economic recovery.
While the Fed has ended its QE policy, others, notably the European Central Bank (ECB), are now following its lead to jumpstart growth. The predictable results are falling term premia in those bond markets. However, US term premia are unexpectedly also being dragged into negative territory, despite better economic conditions and the Fed’s stated intention to begin raising its key interest rate sometime later this year. In other words, US assets are getting additional stimulus, which is long-term bullish.
How will the Fed react? The risk, which credit markets may have yet to fully price, is that US policymakers could try to reverse falling US term premia by raising investor expectations for higher rates. This would likely push up risk premia for US assets. In Europe, QE is just beginning, and risk premia will likely fall.
In this environment, risk premia dominate asset-price valuations, and policy support that reduces risk premia trumps other economic valuations. In setting allocations, value investors need to make risk premia a key input.
Get the full report, “Influence of Risk Premia on Asset Allocation Decisions,” by Jim Caron, Managing Director of Morgan Stanley Investment Management, and explore more Ideas from Investment Management.