Wednesday, April 18, 2007

The Return of Volatility

With the recent choppiness in the markets, investors have become aware that stocks don’t always just trend nicely straight up.

Marc D. Stern, the chief investment officer at Bessemer Trust said in a recent interview, “We are in for some meaningful volatility for the next several years, and none of us should be surprised by that. There are lots of uncertainties to ponder.”

Investors have gotten used to extremely low levels of volatility and they may find these normal price swings disconcerting. To put this in perspective, I’ve included the adjacent chart of the Chicago Board of Trade’s VIX index. This index measures volatility based on investors’ use of options on the S&P 500-stock index. It spiked in early March from historically low levels (see the far left portion of the top chart). As the graph shows, equity volatility is near the historical average but far from the high levels (peaks on the graph) experienced during the dot-com bust in the early 2000’s. Bounces in the market are normal. A 3.5% one-day loss in the U.S. markets like the one experienced at the end of February is not unprecedented after seven straight months of gains totaling over 14%.

What is interesting is how little investors are being paid for taking greater risk especially in the bond market. The bottom graph illustrates this point. It shows the difference in return earned (spread) in a risky investment (in this case High Yield Bonds and Foreign Emerging Country Debt) compared to what is considered a risk less investment in ten year U.S. Treasuries. High Yield bonds are loans made to corporations that have compromised credit. These bonds are risky because they could default (not pay). So to compensate investors for this risk they pay a higher interest rate. The amount of additional interest compared to U.S. Treasuries varies over time. Currently these High Yield bonds are paying a historically low premium compared to the risk free Treasuries (free of credit risk).

Investors are earning less of a premium despite the increasing volatility (another measure of risk) shown in the top chart. In other words, investors are not being paid enough of a premium for the risk they are taking. Investors have become complacent about risk. They have been so focused on chasing higher yields that they have forgotten that they could easily lose money in these riskier investments.

Investors beware. Risk is back and she can be a cruel mistress!
The Financial Pragmatist
Libby Mihalka

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