In examining financial markets it is always interesting to observe how investors attitude for risk changes. Not surprisingly, when markets are doing poorly people become risk averse, and likewise when stocks are performing well investors typically are more optimistic. Recently, as the stock market has been hitting multi-year highs, investors have become more optimistic.
A good place to look at risk tolerance is the bond market. When spreads between U.S. Treasuries and high yield or “junk” bonds are large, investors are risk averse. This was certainly the case during the recent recession when junk bond yields peaked around 20%. Currently these same bonds are yielding around 6%, which is clearly a dramatic turnaround.
Some may think that 6% still looks attractive when 10 -year Treasuries are yielding just below 2%. However, the current difference or spread between the two types of bonds is only 4%, which is near historic lows. This might imply that investors are becoming too optimistic with riskier bonds.
In international markets there appears to be an increased appetite for risk. Countries with higher levels of debt, such as Spain and Italy, have recently seen their government bond yields drop a full percentage point. The Euro has also recently gained strength against the Swiss Franc, which is considered a very strong currency, after the Euro had lost ground to the franc in recent years.
This increased tolerance for risk should be positive for business activity. Most companies do not have AAA ratings that allow for them to borrow at the most favorable rates. While bank credit may still be somewhat stringent, corporations that have access to the bond market can obtain financing at relatively attractive rates.
Bonds have provided solid returns over the past decade. However, as yields have become very low on Treasuries and higher quality corporate bonds, more people have recently gravitated towards higher yield bonds.
Junk bonds did very well in 2012. providing an average total return of 14%. However, I would not recommend a significant weighting in riskier bonds at this time, since those types of returns will likely not be maintained.
Recently money has started to come back into stock- based mutual funds. While the stock market has done well over the past year, on most measures its valuation appears reasonable. For someone who has a longer term time horizon who was over invested in bonds, moving money into stocks would be appropriate.
However, I would not advocate moving money into stocks just because they have been doing well recently, if you already have a decent percentage.
To achieve long term goals requires undertaking some risk. There are times when riskier assets are bargains, and other time when the price of those assets is not worth the risk. Currently investors have become less fearful, which lowers the potential return of riskier assets.