Europe

GLOBAL INVESTOR 1.14 — 61
the expected return of an asset is a function
of the risk-free rate, the risk premium of a
diversified (market) portfolio and how much
risk the asset contributes to this portfolio
(also known as beta).
In practice, the risk premium is often inferred
from history. According to the Credit
Suisse Investment Returns Yearbook, which
provides estimates of risk premia for different
asset classes since the start of the 20th century,
global equities have generated a return
of 4.3% in excess of the risk-free rate (the
US Treasury bill), while the excess returns on
US equities have been 5.5%. Practitioners
often compare asset returns or yields to the
long-term trends in order to understand the
impact that positive and negative economic
shocks can have on valuations. At the time of
writing, US equities are slightly above their
trend since 1849, but not excessively so. As
Figure 1 suggests, equities can spend entire
decades above or below trend.
Some valuation methodologies estimate
the discount rate by reversing the problem of
asset pricing: instead of estimating the fair
price of an asset, they estimate the rate that
makes discounted cash flows equal the market
price for the asset class (see Figure 2). This
at the single security level (a method used by
Credit Suisse HOLT). Alternatively, it can be
compared to its own history, as well as other
financial variables like implied volatility and
credit yields to gauge whether an asset is
fairly valued and to conduct scenario analyses
(a method favored by Credit Suisse strategists).
HOLT’s implied discount rate methodology
indicates that equities are currently
trading at a premium relative to their historic
average but at a discount relative to government
bonds.
Choosing between competing methodolo-
often determined by data availability. No
valuation methodology is ironclad as they all
they are extremely useful for investors who
use them properly and are able to understand
Antonios Koutsoukis
Fundamental Micro Themes Research
+44 20 7883 66 47
antonios.koutsoukis@credit-suisse.com
BOND SPREADS
TEXT JAMES GAVIN
Sovereign bond spreads are the difference
between yields issued by governments with
high and low credit ratings. Bonds that have
a lower rating – for example in an emerging
market – carry a higher yield due to the perception
of additional risk involved in buying
the debt. Widening or narrowing spreads can
reflect perceived differences in central bank
policies as well as economic growth prospects.
Bond spreads are therefore used to
compare risk between markets.
A bond yield mainly has two components –
interest rate risk and credit risk (plus a bit of
liquidity risk). Some investors are happy to
carry all the risk, but when interest rates are
expected to rise, bond prices fall, leading to
capital loss. Consequently, investors may
try and strip out the interest rate risk by
hedging or doing long-short trades on bonds
(or combinations of bond and credit default
The role of rating agencies: Chicken or egg?
swaps). Thus they get exposed only to
credit risk.
There are several techniques for measuring
spreads. One is by yield differential, i.e.
calculating the difference between equivalent
sovereign notes. The second is by the
so-called credit default swap (CDS) differential.
The first method is based on traded
prices, for example, 10-year government
bonds are physically traded in the market,
providing a physical price signal. The second
is a derivative.
The sovereign CDS
component of capital markets, providing a
means for estimating individual sovereign
risk by taking out insurance against default:
the buyer pays a default swap premium,
usually expressed in terms of basis points.
Typically, CDS trading volumes are much
higher, react more rapidly, and at times are >
The narrowing of bond spreads in 2014 bears a relation to the trajectory of the European
economic recovery, with growing belief that the worst is over. The yield story says much
about investor sentiment and the urgency with which many are looking for yield – including
That bullish sentiment, though, is based at least in part on signals provided by the
Sovereign investment grade status is often associated with lower spreads in international
markets. In a study of 35 emerging markets between 1997 and 2010, the International
found that investment-grade status reduces spreads by 36%, above and
beyond what is implied by macroeconomic fundamentals.
The decline in European periphery yields follows positive ratings assessments, such as
Fitch Ratings increasing its risk rating for sovereign debt in Greece and Spain and announcing
an improvement in its outlook for Ireland, Cyprus, Italy and Portugal.
Investors rebalance their portfolios across markets to reduce exposure to riskier borrowers,
and they factor in the rating agencies assessments. But there is a chicken-and-egg situation.
In general, credit ratings tend to be slow and reactive, and spread movements lead to rating
changes, rather than the other way round. So spread changes can become a leading indicator
of fundamental improvement signals in an economy, which ultimately leads to rating changes.