(July 26, 2012) — In times of massive financial stress, there is a pivotal point where the riskiness of equities and bonds start to move together, an aptly-timed paper has claimed.
In a study to unravel the equity risk premium (ERP) Fulcrum Asset Management discovered that in “disaster” scenarios the risk of holding bonds becomes as high as that for holding equities.
The key to the argument is to accommodate the potential for default of a bond, the paper claims.
“At one end of this spectrum, the probability of default is low and bonds behave like a safe haven or risk-free asset as in standard asset pricing models. In this case, the rational flight to safety increases the price of bonds and lowers yields. At the other extreme, the probability of default is high, and bonds become as risky as equities in a disaster-struck world,” states the paper.
As a result, investors demand a higher rate of return as they fear they may lose out both in income and capital preservation terms. Usually, however, this return has not been as high as that demanded for holding equities.
“Analysis of peripheral European equity markets suggests there is a link between the probability of default and the bond-equity correlation, as predicted by the model,” the paper continues. “Correlation shifts have taken place in Greece, Spain, Italy as well as France over the past three years at default probabilities of around 3% per annum.”
The paper concludes that initially the risk associated with holding bonds and equities moves in different directions in time of financial stress, but a threshold is then crossed and they then move in tandem.
For investors this could be important to note, the paper adds, as the current period of financial instability does not look set to change soon.
“Financial markets in the major advanced economies enjoyed a period of unusually low disaster risk during the second half of the 20th century. This has changed in the first part of this century during which several countries have suffered large hits to GDP and teetered close to formal ‘disasters’. Continued problems within the Eurozone together with high levels of government indebtedness suggest the risk of extreme economic outturns will remain high. If so, disaster risk will continue to influence bonds and the analysis here provides a useful framework to think through the consequences.”
To access the full paper, click here.