Are interest-rate and credit risk again priced too low?
Interest-rate risk (i.e., the price risk of longer duration bonds to rising yields) is gauged by the difference between long- and short-term Treasury rates, or interest-rate spread. The greater the difference, the higher are expected future interest rates – reflecting elevated budget deficit or inflation risks. Credit risk (i.e., the price risk of lower quality bonds to default), on the other hand, is gauged by the difference between corporate and Treasury rates of comparable maturity, or corporate credit spreads. Wider corporate credit spreads reflect greater perceived risk of corporate defaults. Generally speaking, wide credit or interest-rate spreads are associated with periods of economic uncertainty. An extreme case occurred starting in 2007 at the inception of the financial meltdown with both credit and interest-rate spreads spiking upward and equity prices plunging.
Narrowing credit and interest-rate spreads along with rising equity prices over the last few years, similar to the period prior to 2007, largely reflect an extremely accommodative monetary policy by the Fed. This has greatly reduced perceived risk. Going forward, however, the Fed’s ballooning balance sheet as well as mounting federal deficits and outstanding corporate debt will again lead to a sharp upward repricing of risk – reversing recent trends.
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