The Amazing Decline of Risk

One of the points I’ve tried to make this year is that financial markets are up, not so much due to a bubble in expectations, but rather it’s been the result of a tremendous fear bubble deflating. Valuations aren’t extreme. They’ve gone from low to somewhat moderate.

We can see another good example by looking at credit spreads. Here’s the yield of a Junk Bond Index (the blue line) compared with AAA Bonds (the red line).

Notice how the spread between the two has narrowed considerably. When markets get nervous, the marginal borrower gets elbowed aside. Well, in 2008, he didn’t just get elbowed — he got a super-atomic wedgie. The world was collapsing and no one wanted to make any junk loans.

The problem is that wider credit yields, in turn, hurt the economy. But as credit markets chill out, those spreads narrow. This reflects the fact that lenders now have more confidence in lending. The downside of this is the lenders can become sloppy and gradually ignore real risks, like we saw during the credit bubble. I’m not saying we’re there yet, but that’s the conventional undoing of tight spreads.

Notice how the problems in Europe caused a big spike in Junk Yields in late 2011. That was an unusual time for investors because financial markets greatly over-reacted to the actual risks at hand. Of course, their skittishness was understandable given what happen only three years before. It’s the unwinding of this fear bubble that’s driven a lot of our gains this year.

Posted by Eddy Elfenbein on December 10th, 2013 at 3:10 pm

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.