Risk Premiums – Equity, Credit, Volatility: Which Premium to Prefer? – invest.ch

Since the beginning of this year 2022, inflation and the rise in interest rates have strongly influenced the markets in terms of performance. Within an allocation, it is important to take stock of the relationship between risk premiums.

By Alexandre Ryo, Head of Development, Overlay & Customized Portfolio Solutions business

The stock market risk premium

For once, our focus here is on the US market, which has been hardest hit by the Fed’s rate hike and monetary policy. In particular, when we analyze the S&P500 and its risk premium based on earnings expectations per share, we find that its negative performance this year and its re-rating are explained almost entirely by the rise in interest rates.

06/24/2022.Risk premium measures

As we can see in the chart below, despite the S&P500 falling more than 20% in 2022, the gap between the equity risk premium and interest rates remains compressed at 2.5% currently. This level remains at its 10-year lows and has yet to undergo a re-evaluation like the ones we saw during periods of stress like 2020, 2015 or even 2018 during the last EDF taper.

06/24/2022.Risk vs Rate

A risk premium based on strong growth expectations

By definition, the stock market risk premium is based on expected outcomes versus the market price. After the previous study, it’s worth dwelling on these earnings predictions for a moment to gauge whether or not this level of compressed risk premium seems logical.

06/24/2022.Risk premium

Analysts are therefore expecting earnings growth of 18% for 2022 and then 9% in 2023. It’s worth forgetting about the Covid era and comparing these forecasts to 2019 to highlight expected annual growth. In summary, the current risk premium therefore expects earnings growth of 12/13% for the next few years. So the equity risk premium would be even more expensive if 0% 1% 2% 3% 4% 5% 6% 7% 8% 01/04 10/06 07/09 04/12 12/14 09/17 06 /20 23.03. 25.12. Spread Risk Premium vs. Rate 3 this earnings growth was not achieved; For example, a 2023 outcome that would remain neutral compared to 2021 would result in an equity risk premium versus interest rates of 1.3% instead of 2.5%.

Comparison of the equity risk premium with the credit risk premium

Having analyzed the equity risk premium, which we may find excessive at the moment, it should be compared to other risk premiums in order to put it in a more general context. So if we look at the option-adjusted spread of the investment grade and high yield indices in the US market, we get the following chart:

06/24/2022.Spread options

As we can see here, a re-rating is taking place in the credit markets, both investment grade and high yield. As equities are a real asset with the allure of inflation-indexed results, this differential response may be justified. However, it will be necessary to avoid recession risk or global deleveraging related to the increase in risk (volatility of risky assets). Through a more detailed analysis, particularly based on investment grade, we see here that the equity risk premium could be repriced up 1%. In this case, given the S&P500 index is currently at 3750 points, a 1% repricing of the risk premium would send the index down -15%.

2022.06.24.spread IG

Exploring optional bonuses and associated returns

An easy way to get a fixed return, and therefore a credit-like product, thanks to the stock market is to use the options market. Many structured products, sellers of protection against the market downturn, are created based on this strategy. Here we are simply looking at the 1-year put option level that must be sold on the S&P500 to achieve a similar return to an investment grade investment. It is reasonable to sell the level currently at -37% for a 1.7% yield similar to investment grade. Historically, that level seems far off compared to what we could have had. However, it needs to be put in context according to what we described earlier. If the equity risk premium were to approach the credit risk premium, the stock market would actually have to be 15% lower. The option written would therefore no longer be at -37%, but at -22%, which historically seems very close. Should it come to that, this revaluation would only be linked to the risk premium. A decrease in the expected results and their strong growth would also lead to a significant re-rating of the index, bringing the level of this put sold by construction closer.

2022.06.24.Strike Put

Conclusion

This analysis therefore underscores the fact that the stock market currently does not appear to be expecting a decline in earnings growth or even a repricing of the risk premium associated with a simple exchange of flows between different asset classes. On the other hand, hedging flows have affected option premiums, which offset these high equity market costs and may now appear more attractive than credit risk premiums. However, we must not forget the risk associated with potential repricing of equities in these derivatives.

Therefore, today it seems more interesting to encourage the fixed yield of credit investments (investment grade or high yield) that have already suffered a negative risk premium effect and to limit the risk of a revaluation of the equity markets by maintaining hedging options that could be activated more quickly, than we imagine, especially given the high realized volatility in stock markets today.


Warning : This commercial document does not constitute investment advice or a recommendation to buy or sell any financial product. Investors intending to subscribe to units or shares of UCI are advised not to base their decision solely on the elements contained in this document and to consult the latest version of the carefully read the prospectus and in particular the risk profile. The UCI prospectuses and KIIDs are available upon request from the Management Company or on the website www.ellipsis-am.com. The distribution and offering of shares or units of UCIs may be restricted or prohibited by law in certain jurisdictions. The UCI may not be subscribed for or held by a non-approved person or intermediary (see the “Eligible Subscribers” section of the Prospectus). Before subscribing, you should check in which countries the UCIs mentioned in this document are registered.

Disclaimer for overlay solutions: its objective is to reduce the risks of a given portfolio without eliminating them completely and does not aim to offer any guarantee or protection of the portfolio, which therefore remains exposed to the risk of capital loss. In particular, this solution is also subject to a model risk linked to the implementation of the main objective of risk reduction, based on a systematic principle. There is a risk that this model is not efficient. Finally, in addition to the specific risks linked to the existing portfolio, this solution introduces risks linked to the use of financial futures instruments and an operational risk. Due to the existence of hedging, the potential return could be lower due to the impact of hedging costs and the fact that the portfolio could only partially participate in the upside should the market rally.

ELLIPSIS AM – 112 avenue Kleber – 75116 Paris – Portfolio management company authorized by the AMF under number GP-11000014 – SA with Management Board and Supervisory Board with share capital of 2,307,300 euros – RCS Paris 504 868 738.


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