Abnormal Can Still Be Rational

November 22, 2017

However, macro-level irrational pricing is extremely rare, and one would be hard-pressed to identify today’s low-risk environment as irrational. In this period of record-low volatility, the recovery in global economic growth from the 2015 commodity price collapse scare has produced a more stable backdrop in which lower volatility can be priced into historically risky assets.

Is this notion of fair versus rational just a matter of semantics? Not necessarily. Investors need to be mindful of the difference.

My own judgment could be that today’s credit markets are expensive and do not adequately compensate fixed-income investors for default risk. But my personal judgment of what constitutes normal or fair pricing is just one opinion that feeds into aggregate market pricing.

The majority of other fixed-income investors likely feel comfortable with the thin margins priced into credit risk. Does this euphoric sentiment rise to the level of irrationality given the context of the global economic environment? Market pricing may be unfair or abnormal, but not necessarily irrational.

One could argue that credit markets are irrationally pricing in default risk if the spread for compensating default risk is extremely low versus the expected default outlook. For instance, prior to last week’s sell-off, high-yield credit spreads (above risk-free fixed income) dropped below 3% in late October (Figure 2), even though Moody’s is projecting 2.3% default rate over the next year.

 

Figure 2: Fixed-Income Credit Spreads: Expensive But Irrational?

Falling Risk Premiums Can Be Rational

For a larger view, please click on the image above.

 

Investors don’t seem to be “fairly” compensated for sub-3% credit spreads in the face of 2.5% expected default risk, but would such narrow spreads be considered to be ‘irrationally-priced’? What if, instead, the spread was 1% and the expected default rate was 5%?

One could more easily argue that a negative, default-adjusted spread reflects irrational pricing, although it would also depend on whether fixed-income investors were pricing in a much more benign credit environment following the spike in defaults. Yet such a scenario is unlikely, as high-yield spreads have historically priced in expected default rates.

2008 Financial Crisis Part Of Systemwide Irrational Pricing?

However, such systemwide, irrational pricing events rarely, if ever, occur in well-functioning capital markets characterized by diverse, knowledgeable, and independent participants.

University of Chicago professor Eugene Fama received quite a bit of flack for refusing to acknowledge whether or not the credit events that led to the 2008 financial crisis reflected a credit bubble in housing.

Underlying his response is this notion that it’s unlikely we can identify a credit bubble ahead of time, even if such a bubble is staring at us in the face. Recall that it took several years for the “Big Short” investor thesis to play out, and several of those “professionals” almost went out of business before their shorts finally paid off as the global financial crisis unfolded.

For those who’ve studied this historical episode, many observers assign ground zero blame to the credit rating agencies for modeling housing price appreciation into near perpetuity, assumptions that made their way through the mortgage creation pipeline exposing great swaths of the global financial system to a housing downturn that did finally arrive in 2008.

Irrational pricing of risk assets before 2008? Perhaps, but one could argue there was still a reasonable basis for the assumptions used in those models. U.S. housing could have appreciated at a single-digit rate for the foreseeable future (admittedly, 30 years would be stretching it), but unless some forensic investigator had uncovered willful deception and fraud at the rating agencies, these were models of mortgage risk built on presumably historically based inputs.

 

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