In financial theory, the rate of return at which an investment trades is the sum of five different components: the risk-free rate, inflation premium, liquidity premium, default risk premium, and maturity premium. Over time, asset prices tend to reflect the impact of these components fairly well.
For those of you who want to learn to value stocks or understand why bonds trade at certain prices, these components are an important part of the foundation.
The Real Risk-Free Interest Rate
This is the rate against which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation. While it isn't truly "risk-free," Treasuries are typically used as a practical compromise for calculating the risk-free rate. Investors should use a term that reflects their timeline, so a short-term investor might reference the three-month Treasury bill as the risk-free rate.
This is the rate that is added to an investment to adjust it for the market’s expectation of future inflation. For example, the inflation premium required for a one-year corporate bond might be a lot lower than a 30-year corporate bond by the same company because investors think that inflation will be low in the short term, but pick up in the future as a result of the trade and budget deficits of years past.
Some investments don't trade very often, and that presents a risk to the investor. Thinly traded investments such as family-controlled company securities require a liquidity premium. That is, investors are not going to pay the full value of the asset if there is a very real possibility that they will not be able to dump the stock or bond in a short period of time because buyers are scarce.
A liquidity premium is expected to compensate investors for that potential loss. The size of the liquidity premium is dependent upon an investor’s perception of how active a particular market is.
Liquidity risk is less of an issue for investors who trade blue-chip stocks and other popular securities. Investors may even be willing to pay more for those securities over similar, less liquid alternatives.
Default Risk Premium
Do investors believe a company will default on its obligation or go bankrupt? Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of investors demanding a default risk premium.
A security price collapse can present opportunities. If someone were to acquire assets that were trading at a huge discount as a result of an unreasonably large default risk premium, they could make a great deal of money.
Many asset management companies will seek out these opportunities. Kmart presented an example of this in the early 2000s. Before the retailer's 2002 bankruptcy, distressed debt investors bought an enormous portion of its debt. When the company was reorganized in bankruptcy court, the debt holders were given equity in the new company. One such investor, Edward Lampert, gained a controlling block of Kmart stock through his debt purchases, and he was able to use that control to improve the company's balance sheet and get Kmart out of bankruptcy.
The further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium, otherwise known as interest rate risk.
Here’s a simplified example to illustrate the concept. Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest. In 30 years, you will get your original $10,000 back. If you were going to sell your bond the next day, you would likely get around the same amount, because that 7% interest rate isn't likely to change overnight.
However, interest rates do change. Consider if interest rates rise to 9% a year after you bought the bond. You want to sell your bond, but no investor is going to accept your 7% bond because they could go to the open market and buy a new bond that yields 9%. They will only pay a lower price for your bond, not the full $10,000, to effectively increase their yield to 9%.
Longer maturities are subject to greater risk of capital gains or losses because there is more time for the interest rate environment to change. Had interest rates fallen, the bondholder would have been able to sell their position for much more. If rates rose even higher, their bond would be worth even less.