Swedroe: A Closer Look At Evaluating Risk

Nils Friewald, Christian Wagner and Josef Zechner—authors of the study “The Cross-Section of Credit Risk Premia and Equity Returns,” which appears in the December 2014 edition of the Journal of Finance—studied the relationship between a firm’s default risk and that firm’s equity premium.

Their study covered the 10-year period from 2001 through 2010, and estimated credit risk premiums from the credit default swap (CDS) forward curve.

The financial theory behind the study posits that the risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. In other words, information incorporated in the market for a company’s credit instruments, such as CDSs, must be connected to expected returns on its equity.

The authors found that when they sorted firms by their estimated equity risk premium, there was “a strong positive relation between credit risk premia and equity excess returns. Stock returns decrease from the portfolio of firms with highest to the portfolio of firms with lowest credit risk premia.”

They discovered that buying high-credit-risk premium firms and selling low-credit-risk premium firms generates significantly positive excess returns (alpha) with each of the asset pricing models they examined—the single-factor (beta) CAPM; the Fama and French three-factor model (beta, size and value); and the four-factor Carhart model (beta, size, value and momentum).

The authors also found that the high-credit-risk portfolio minus the low-credit-risk portfolio continues to earn significant alphas after controlling for common characteristics. Excess returns were highest for small firms, value stocks and firms with high-default probabilities. These findings are consistent with the general notion that small firms and value firms earn comparably higher stock returns (because they are exposed to higher distress risk) than larger firms or firms with lower book-to-market ratios.

The researchers also noted their finding; namely, that credit risk premia are significantly priced in all size and book-to-market portfolios, and that it only strengthens their argument that credit risk premia estimated from CDS spreads contain information not captured by size and value factors.

For example, they found that four-factor alpha decreases from 2.88 percent per month to 0.17 percent for firms with high CDS spread levels compared with firms with low CDS spread levels. And the data is statistically significant.

The authors also noted that their results were robust when splitting the full sample period (January 2001 to April 2010) into pre-crisis (January 2001 to June 2007) and crisis (July 2007 to April 2010) subsamples. They found that outcomes didn’t depend on whether they calculated equal- or value-weighted portfolio returns. Furthermore, they remained unchanged when excluding financial and utility firms.

These findings are all consistent with economic theory, which is always good to see. In addition, they demonstrate that there’s little unique risk in corporate debt because the default risk is related to, and priced in, the equities of the issuers. It’s also worth observing that equity risk is easier and less costly to diversify. And for taxable investors, the risk premium is earned in a more tax-efficient manner.

When we also consider the fact that the default premium—the return on long-term corporate bonds minus the return on long-term Treasury bonds—has been only about 0.2 percent per year, and the fact that credit and equity risk are positively related (thus, credit risk doesn’t mix well with equity risks because crashes tend to happen at the same time), then including credit risk in the bond portion of the portfolio is not an efficient way to construct it.

It’s more efficient to take the risk on the equity side.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.