The Equity Premium From The Perspective Of A Bond Manager

A Bond Manager Thinks about the Equity Premium by David Merkel, CFA of Aleph Blog

One of the things that annoys me about the concept of the equity premium is that it is an academic creation that does not grasp the structures of the markets.  Send the academics to be bond and equity portfolio managers for a time, and maybe we would get a better theory than Modern Portfolio Theory [MPT].

Here is the first thing that is wrong with MPT — it doesn’t understand the bond market.  The best estimate of what bonds will return over time is the current yield less expected losses from defaults and optionality.  Hold a bond to its maturity, and the standard deviation of returns is low, over the full time horizon.

Thinking about bonds in the current environment, virtually nothing is earned with high-quality short-dated debt.  The yield curve is still relatively steep, as people expect the economy and lending to pick up.

Think for a moment. what is a longer asset, a corporate bond, or the stock of the same company?  The stock is the longer asset, because the cash flows of the business in question potentially stretch far longer than the maturity of the corporate debt, at least in most cases.

Also think, in a bad scenario, where insolvency is possible, who has the better claim: the equity or the unsecured debt?  The unsecured debt, of course.

Longer assets in general possess more risk and should carry higher yields to induce people to take those risks.  Inverted yield curves are exceptions.  Also in general, longer corporate bonds have higher spreads over Treasuries most of the time, than shorter corporate bonds.

The one significant advantage that equities have over corporate bonds is that of control.  Increases in earnings go to the stockholders.  Buyouts go to the stockholders.  Bondholders get paid off at best.

That said, in the losing scenario, bondholders get back 40% of par on average, while stockholders get little if anything.

I believe that the equity of a company needs to be priced to return more than the longest unsecured debt or preferred stock of the company.

Thus when I think about MPT, I think they are positing an asset-liability mismatch, comparing T-bills versus a long asset, common stocks.  The comparison should be broken down into several spreads:

  • T-bills vs T-notes/bonds of the longest maturity issued by companies like them.
  • Corporate bond yields minus Treasury yields at the same maturity.
  • The earnings yield of the stock minus the corporate bond yield.

This takes apart the seemingly simple MPT calculation, revealing the complexity within, helping to explain why beta doesn’t work.  It embeds an asset-liability mismatch.  Stocks are long term, T-bills are not.  There is no reason why their returns should be considered together, without a model of yield curve spreads, corporate spreads, and equity financing spreads.

That’s a sketch of the correct model, now who wants to try to build it out?

The Equity Premium From The Perspective Of A Bond Manager



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.