Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!

    There is a reason that every religion inveighs against borrowing money, driven by a history of people and businesses, borrowing too much and then paying the price, but a special vitriol is reserved for the lenders, not the borrowers, for encouraging this behavior. At the same time, in much of the word, governments have encouraged the use of debt, by providing tax benefits to businesses (and individuals) who borrow money. In this post, I look at the use of debt by businesses, around the globe, chronicling both the magnitude of borrowing, and the details of debt (in terms of maturity, fixed vs floating, straight vs convertible). The tension between borrowing too little, and leaving tax benefits on the table, and borrowing too much, and exposing yourself to default risk, is felt at every business, but the choice of how much to borrow is often driven by a range of other considerations, some of which are illusory, and some reflecting the frictions of the market in which a business operates.

The Debt Trade off

    As a prelude to examining the debt and equity tradeoff, it is best to first nail down what distinguishes the two sources of capital. There are many who trust accountants to do this for them, using whatever is listed as debt on the balance sheet as debt, but that can be a mistake, since accounting has been guilty of mis-categorizing and missing key parts of debt. To me, the key distinction between debt and equity lies in the nature of the claims that its holders have on cash flows from the business. Debt entitles its holders to contractual claims on cash flows, with interest and principal payments being the most common forms, whereas equity gives its holders a claim on whatever is left over (residual claims). The latter (equity investors) take the lead in how the business is run, by getting a say in choosing who manages the business and how it is run, while lenders act, for the most part, as a restraining influence.

Using this distinction, all interest-bearing debt, short term and long term, clears meets the criteria for debt, but for almost a century, leases, which also clearly meet the criteria (contractually set, limited role in management) of debt, were left off the books by accountants. It was only in 2019 that the accounting rule-writers (IFRS and GAAP) finally did the right thing, albeit with a myriad of rules and exceptions. 

    Every business, small or large, private or public and anywhere in the world, faces a question of whether to borrow money, and if so, how much, and in many businesses, that choice is driven by illusory benefits and costs. Under the illusory benefits of debt, I would include the following:

1. Borrowing increases the return on equity, and is thus good: Having spent much of the last few decades in New York, I have had my share of interactions with real estate developers and private equity investors, who are active and heavy users of debt in funding their deals. One reason that I have heard from some of them is that using debt allows them to earn higher returns on equity, and that it is therefore a better funding source than equity. The first part of the statement, i.e., that borrowing money increases the expected return on equity in an investment, is true, for the most part, since you have to contribute less equity to get the deal done, and the net income you generate, even after interest payments, will be a higher percentage of the equity invested. It is the second part of the statement that I would take issue with, since the higher return on equity, that comes with more debt, will be accompanied by a higher cost of equity, because of the use of that debt. In short, I would be very skeptical of any analysis that claims to turn a neutral or bad project, funded entirely with equity, into a good one, with the use of debt, especially when tax benefits are kept out of the analysis.
2. The cost of debt is lower than the cost of equity: If you review my sixth data update on hurdle rates, and go through my cost of capital calculation, there is one inescapable conclusion. At every level of debt, the cost of equity is generally much higher than the cost of debt for a simple reason. As the last claimants in line, equity investors have to demand a higher expected return than lenders to break even. That leads some to conclude, wrongly, that debt is cheaper than equity and more debt will lower the cost of capital. (I will explain why later in the post.)

Under the illusory costs of debt, here are some that come to mind:

1. Debt will reduce profits (net income): On an absolute basis, a business will become less profitable, if profits are defined as net income, if it borrows more money. That additional debt will give rise to interest expenses and lower net income. The problem with using this rationale for not borrowing money is that it misses the other side of debt usage, where using more debt reduces the equity that you will have to invest.
2. Debt will lower bond ratings: For companies that have bond ratings, many decisions that relate to use of debt will take into account what that added debt will do to the company’s rating. When companies borrow more money, it may seem obvious that default risk has increased and that ratings should drop, because that debt comes with contractual commitments. However, remember that the added debt is going into investments (projects, joint ventures, acquisitions), and these investments will generate earnings and cash flows. When the debt is within reasonable bounds (scaling up with the company), a company can borrow money, and not lower its ratings. Even if bond ratings drop, a business may be worth more, at that lower rating, if the tax benefits from the debt offset the higher default risk.
3. Equity is cheaper than debt: There are businesspeople (including some CFOs) who argue that debt is cheaper than equity, basing that conclusion on a comparison of the explicit costs associated with each – interest payments on debt and dividends on equity. By that measure, equity is free at companies that pay no dividends, an absurd conclusion, since investors in equity anticipate and build in an expectation of price appreciation. Equity has a cost, with the expected price appreciation being implicit, but it is more expensive than debt.

The picture below captures these illusory benefits and costs:

If the above listed are illusory reasons for borrowing or not borrowing, what are the real reasons for companies borrowing money or not borrowing? The two primary benefits of borrowing are listed below:

• Tax Benefits of Debt: The interest expenses that you have on debt are tax deductible in much of the world, and that allows companies that borrow money to effectively lower their cost of borrowing: 

    After-tax cost of debt = Interest rate on debt (1 – tax rate) 

In dollar terms, the effect is similar; a firm with a 25% tax rate and $100 million in interest expenses will get a tax benefit of $25 million, from that payment.  

• Debt as a disciplinary mechanism: In some businesses, especially mature ones with lots of earnings and cash flows, managers can become sloppy in capital allocation and investment decisions, since their mistakes can be covered up by the substantial earnings. Forcing these companies to borrow money, can make managers more disciplined in project choices, since poor projects can trigger default (and pain for managers).

These have to be weighted off against two key costs:

1. Expected bankruptcy costs: As companies borrow money, the probability that they will be unable to make their contractual payments on debt will always increase, albeit at very different rtes across companies, and across time, and the expected bankruptcy cost is the product of this probability of default and the cost of bankruptcy, including both direct costs (legal and deadweight) and indirect costs (arising from the perception that the business is in trouble).
2. Agency costs: Equity investors and lenders both provide capital to the business, but the nature of their claims (contractual and fixed for debt versus residual for equity) creates very different incentives for the two groups. In short, what equity investors do in their best interests (taking risky projects, borrow more money or pay dividends) may make lenders worse off. As a consequence, when lending money, lenders write in covenants and restrictions on the borrowing businesses, and those constraints will cause costs (ranging from legal and monitoring costs to investments left untaken).

The real trade off on debt is summarized in the picture below:

While the choices that businesses make on debt and equity should be structured around expected tax benefits (debt’s biggest plus) and expected bankruptcy costs (debt’s biggest minus), businesses around the world are affected by frictions, some imposed by the markets that they operate in, and some self-imposed. The biggest frictional reasons for borrowing are listed below:

1. Bankruptcy protections (from courts and governments): If governments or courts step in to protect borrowers, the former with bailouts, and the latter with judgments that consistently favor borrowers, they are nullifying the effect of expected bankruptcy costs in restraining companies from borrowing too much. Consequently, companies in these environments will borrow much more than they should.
2. Subsidized Debt: If lenders or governments lend money to firms at below-market reasons for reasons of virtue (green bonds and lending) or for political/economic reasons (governments lending to companies that choose to keep their manufacturing within the domestic economy), it is likely that companies will borrow much more than they would have without these debt subsidies.
3. Corporate control: There are companies that choose to borrow money, even though debt may not be the right choice for them, because the inside investors in these companies (family groups, founders) do not want to raise fresh equity from the market, concerned that the new shares issued will reduce their power to control the firm. 

The biggest frictional reasons for holding back on borrowing include:

1. Debt covenants: To the extent that debt comes with restrictions, a market where lender restrictions are more onerous in terms of the limits that they put on what borrowers can or cannot do will lead to a subset of companies that value flexibility borrowing less.
2. Overpriced equity: To the extent that markets may become over exuberant about a company's prospects, and price its equity too highly, they also create incentives for these firms to overuse equity (and underutilize debt). 
3. Regulatory constraints: There are some businesses where governments and regulators may restrict how much companies operating in them can borrow, with some of these restrictions reflecting concerns about systemic costs from over leverage and others coming from non-economic sources (religious, political).

The debt equity trade off, in frictional terms, is in the picture below:

As you look through these trade offs, real or frictional, you are probably wondering how you would put them into practice, with a real company, when you are asked to estimate how much it should be borrow, with more specificity. That is where the cost of capital, the Swiss Army Knife of finance that I wrote about in my sixth data update update, comes into play as a debt optimizing tool. Since the cost of capital is the discount rate that you use to discount cash flows back to get to a value, a lower cost of capital, other things remaining equal, should yield a higher value, and minimizing the cost of capital should maximize firm. With this in place, the “optimal” debt mix of a business is the one that leads to the lowest cost of capital:

You will notice that as you borrow more money, replacing more expensive equity with cheaper debt, you are also increasing the costs of debt and equity, leading to a trade off that can sometimes lower the cost of capital and sometimes increase it. This process of optimizing the debt ratio to minimize the cost of capital is straight forward, and if you are interested, this spreadsheet will help you do this for any company.

Measuring the Debt Burden

    With that tradeoff in place, we are ready to examine how it played out in 2024, by looking at how much companies around the world borrowed to fund their operations. We can start with dollar value debt, with two broad measures – gross debt, representing all interest-bearing debt and lease debt, and net debt, which nets cash and marketable securities from gross debt. In 2024, here are the gross and net debt values for global companies, broken down by sector and sub-region:

The problem with dollar debt is that absolute values can be difficult to compare across sectors and markets with very different values, I will look at scaled versions of debt, first to total capital (debt plus equity) and then then to rough measures of cash flows (EBITDA) and earnings (EBIT). The picture below lists the scaled versions of debt:

1. Debt to Capital: The first measure of debt is as a proportion of total capital (debt plus equity), and it is this version that you use to compute the cost of capital. The ratio, though, can be very different when you use book values for debt and equity then when market values are used. The table below computes debt to capital ratios, in book and market terms, by sector and sub-region: 
   
   I would begin by separating the financial sector from the rest of the market, since debt to banks is raw material, not a source of capital. Breaking down the remaining sectors, real estate and utilities are the heaviest users of debt, and technology and health care the lightest. Across regions, and looking just at non-financial firms, the US has the highest debt ratio, in book value terms, but among the lowest in market value terms. Note that the divergence between book and market debt ratios in the last two columns varies widely across sectors and regions.
2. Debt to EBITDA: Since debt payments are contractually set, looking at how much debt is due relative to measure of operating cash flow making sense, and that ratio of debt to EBITDA provides a measure of that capacity, with higher (lower) numbers indicating more (less) financial strain from debt.
3. Interest coverage ratio: Interest expenses on debt are a portion of the contractual debt payments, but they represent the portion that is due on a periodic basis, and to measure that capacity, I look at how much a business generates as earnings before interest and taxes (operating income), relative to interest expenses. In the table below, I look at debt to EBITDA and interest coverage ratios, by region and sector: 
   
   The results in this table largely reaffirm our findings with the debt to capital ratio. Reda estate and utilities continue to look highly levered, and technology carries the least debt burden. Across regions, the debt burden in the US, stated as a multiple of EBITDA or looking at interest coverage ratios, puts it at or below the global averages, whereas China has the highest debt burden, relative to EBITDA.

The Drivers and Consequences of Debt

    As you look at differences in the use of debt across regions and sectors, it is worth examining how much of these differences can be explained by the core fundamentals that drive the debt choice – the tax benefits of debt and the bankruptcy cost. 

• The tax benefit of debt is the easier half of this equation, since it is directly affected by the marginal tax rate, with a higher marginal tax rate creating a greater tax benefit for debt, and a greater incentive to borrow more. Drawing on a database maintained by PWC that lists marginal tax rates by country, I create a heat map:

Download corporate tax rates, by country

The country with the biggest changes in corporate tax policy in the world, for much of the last decade, has been the United States, where the federal corporate tax rate, which at 35%, was one of the highest in the world prior to 2017, saw a drop to 21% in 2017, as part of the first Trump tax reform. With state and local taxes added on, the US, at the start of 2025, had a marginal corporate tax rate of 25%, almost perfectly in line with a global norm. The 2017 tax code, though, will sunset at the end of 2025, and corporate tax rates will revert to their old levels, but the Trump presidential win has not only increased the odds that the 2017 tax law changes will be extended for another decade, but opened up the possibility that corporate tax rates may decline further, at least for a subset of companies.

        An interesting question, largely unanswered or answered incompletely, is whether the US tax code change in 2017 changed how much US companies borrowed, since the lowering of tax rates should have lowered the tax benefits of borrowing. In the table below, I look at dollar debt due at US companies every year from 2015 to 2024, and the debt to EBITDA multiples each year:

As you can see, the tax reform act has had only a marginal effect on US corporate leverage, albeit in the right direction. While the dollar debt at US companies has continued to rise, even after marginal tax rates in the US declines, the scaled version of debt (debt to capital ratio and debt to EBITDA have both decreased).

• The most commonly used measure of default risk is corporate bond ratings, since ratings agencies respond (belatedly) to concerns about default risk by downgrading companies. The graph below, drawing on data from S&P< looks at the distribution of bond ratings, from S&P, of rated companies, across the globe, and in the table below, we look at the breakdown by sector: 
  

The ratings are intended to measure the likelihood of default, and it is instructive to look at actual default rates over time. In the graph below, we look at default rates in 2024, in a historical context:

S&P

As you can see in the graph, default rates are low in most periods, but, not surprisingly, spike during recessions and crises. With only 145 corporate defaults, 2024 was a relatively quiet year, since that number was slightly lower than the 153 defaults in 2023, and the default rate dropped slightly (from 3.6% to3.5%) during the year. 

The default spread is a price of risk in the bond market, and if you recall, I estimated the price of risk in equity markets, with an implied equity risk premium, in my second data update. To the extent that the price of risk in both the equity and debt markets are driven by the endless tussle between greed and fear, you would expect them to move together much of the time, and as you can see in the graph below, I look at the implied equity risk premium and the default spread on a Baa rated bond:

Damodaran.com

In 2024, the default spread for a Baa rated dropped from 1.61% to 1.42%, paralleling a similar drop in the implied equity risk premium from 4.60% to 4.33%. 

Debt Design

    There was a time when businesses did not have much choice, when it came to borrowing, and had to take whatever limited choices that banks offered. In the United States, corporate bond markets opened up choices for US companies, and in the last three decades, the rest of the world has started to get access to domestic bond markets. Since corporate bonds lend themselves better than bank loans to customization, it should come as no surprise now that many companies in the world have literally dozens of choices, in terms of maturity, coupon (fixed or floating), equity kickers (conversion options) and variants on what index the coupon payment is tied to. While these choices can be overwhelming for some companies, who then trust bankers to tell them what to do, the truth is that the first principles of debt design are simple. The best debt for a business is one that matches the assets it is being used to fund, with long term assets funded with long term debt, euro assets financed with euro debt, and with coupon payments tied to variables that also affect cash flows. 

There is data on debt design, though not all companies are as forthcoming about how their debt is structured. In the table below, I look at broad breakdowns – conventional and lease debt, long term and short debt, by sector and sub-region again:

The US leads the world in the use of lease debt and in corporate bonds, with higher percentages of total debt coming from those sources. However, floating rate debt is more widely used in emerging markets, where lenders, having been burned by high and volatile inflation, are more likely to tie lending rates to current conditions.

    While making assessments of debt mismatch requires more company-level analysis, I would not be surprised if inertia (sticking with the same type of debt that you have always uses) and outsourcing (where companies let bankers pick) has left many companies with debt that does not match their assets. These companies then have to go to derivatives markets and hedge that mismatch with futures and options, creating more costs for themselves, but fees and benefits again for those who sell these hedging products.

Bottom Line

    When interest rates in the United States and Europe rose strongly in 2022, from decade-long lows, there were two big questions about debt that loomed. The first was whether companies would pull back from borrowing, with the higher rates, leading to a drop in aggregate debt. The other was whether there would be a surge in default rates, as companies struggled to generate enough income to cover their higher interest expenses. While it is still early, the data in 2023 and 2024 provide tentative answers to these questions, with the findings that there has not been a noticeable decrease in debt levels, at least in the aggregate, and that while the number of defaults has increased, default rates remain below the highs that you see during recessions and crises. The key test for companies will remain the economy, and the question of whether firms have over borrowed will be a  global economic slowdown or recession.

YouTube Video

Data Updates for 2025

1. Data Update 1 for 2025: The Draw (and Danger) of Data!
2. Data Update 2 for 2025: The Party continued for US Equities
3. Data Update 3 for 2025: The times they are a'changin'!
4. Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!
5. Data Update 5 for 2025: It's a small world, after all!
6. Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!
7. Data Update 7 for 2025: The End Game in Business!
8. Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!
9. Data Update 9 for 2025: Dividend Policy - Inertia and Me-tooism Rule!

Data Links

1. Debt fundamentals, by industry (US, Global, Emerging Markets, Europe, Japan, India & China)
2. Debt details, by industry (US, Global, Emerging Markets, Europe, Japan, India & China)

Data Update 2 for 2021: The Price of Risk!

Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits.  In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.

The Price of Risk

The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.

Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a positive premium, and the level of the premium will increase, as investors become more risk averse. If, on the other hand, investors are risk neutral, the price of risk will be zero, and investors will buy risky business, stocks and other investments, and settle for the risk free rate as the expected return.

Note that nothing that I have said so far is premised on modern portfolio theory, or any academic view of risk premiums. It is true that economists have researched risk aversion for centuries and concluded that investors are collectively risk averse, and that the level of risk aversion varies across age groups, income levels and time. Some have developed models that try to measure what a fair risk premium should be, but to arrive at their conclusions, they have make assumptions about investor utility functions that are often unobservable and untestable. I have no desire to make this a lengthy treatise about the "right" risk premium, but will instead start with two assertions:

1. Risk premiums can be estimated: You can back out the risk premiums that investors are demanding from the prices that they pay for risky assets. Put simply, if you can observe the price that an investor pays for a risky asset, and are willing to estimate the expected cash flows on that asset, you can estimate the expected return on that asset and net out the risk free asset to arrive at a risk premium. It is true that you can make mistakes on your expected cash flows, but your output should reflect an estimate, albeit a noisy one, of what investors are demanding as a premium.
2. Risk premiums can and will change over time: Risk premiums are driven by risk aversion, and risk aversion itself can change over time. In fact, greed and fear, two big drivers of market prices, also affect risk aversion, with investors becoming more risk averse and charging higher premiums, when the fear factor becomes dominant. 
3. When risk premiums change, prices will move: As risk premiums change, the prices that investors are willing to pay for risky assets will also change, with the two moving in opposite directions. Intuitively, if you want to earn a higher risk premium on an investment, holding cash flows fixed, you will pay less for that investment today.

The Price of Risk: Bond Market

All bonds, including those with guaranteed coupons, are risky, if you define risk as prices being volatile, since as interest rates changes, bond prices will change as well. Most bonds, though, are exposed to a second risk, which is that the bond issuer can default on coupon payments, making returns and prices even more uncertain. This is why corporate bonds are riskier than sovereign bonds, and sovereign bonds issued by shakier governments are riskier than sovereign bonds issued by governments that are unlikely to default. 

Bond Default Spread

If you accept the proposition that a bond with default risk is riskier than an otherwise equivalent bond (same coupon and maturity) issued by a default-free entity, the price of risk in the bond market can be measured by looking at the differences in yields between the two bonds. Thus, if a 10-year corporate bond has a yield of 3.00% and a 10-year government bond, in the same currency and with no default risk, has a yield of 1.00%, the difference is termed the default spread and becomes a measure of the price of risk in the bond market. 

At the risk of belaboring the details, it is not the yield that we should be comparing, but the yield to maturity, which is the internal rate of return on the bond, given how it is priced:

To compute the default spread over a 10-year period for a specific corporate bond (or loan), you would compute the yields to maturity on the ten-year corporate and treasury bonds and take the difference. Note that even this comparison is an approximation, but it yields a close enough value to work, and that it yields a default spread for a specific maturity. You could compute default spreads for other maturities, and compute the price of risk over 1-year, 2-year, 3-year periods and so on. 

Corporate Default Spreads: Current and Look Back at 2020

Corporate bonds are traded, and as a consequence, and you can use traded prices to estimate default spreads in the market. In the chart below, I compare default spreads at the start of 2021 with the default spreads at the start of 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)

At first sight, it looks like an uneventful year, with spreads in 2021 mildly higher than spreads in 2020, but that comparison is deceptive, since default spreads went on a roller-coaster ride during 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)

While spreads started 2020 in serene fashion, the COVID-driven market crisis caused them to widen dramatically between February 14 and March 20, with the spreads almost tripling for lower rated bonds. Given the worries about default and a full-fledged market meltdown, that was not surprising, but what is surprising is how quickly the fear factor faded and spreads returned almost to pre-crisis levels.

Measuring against the past

Are default spreads today too low? There are two ways to answer that question. One is to look at their movement over time, and compare current spreads to historic norms. 

Source: BofA ML Spreads on Federal Reserve (FRED)

The default spreads at the end of 2020 are at the low end of the historical spectrum, and the contrast with the 2008 crisis is stark, since default spread surged in the last quarter of 2008 and did not come back down to pre-crisis levels until almost two years later. The other is to look at corporate defaults over time to see if markets are building in enough of a buffer against future defaults. 

Sources: S&P and Moody's

Default rates increased in 2020, with spillover effects expected into 2021, but the corporate bond default spreads do not seem to reflect this. One explanation is that the bond market beliefs that the worst of the crisis is over and that default rates will return quickly to pre-COVID levels. The other is the corporate bond market is under estimating both the risk and the consequences of default.

The Price of Risk: Equities

Equities are riskier than bonds (or at least most bonds), and it stands to reason that there is a price of risk bearing in the equity markets. While that price has a name, i.e., the equity risk premium, it is more difficult to observe and estimate than the default spread in bond markets. In this section, I will present both the standard approach to estimating the equity risk premium and my preferred way of doing so, with a rationale for why.

Estimation Approaches

Why is it so difficult to estimate an equity risk premium? The simple reason is that unlike a bond, which comes with specified coupons, the cash flows that you receive when you buy stocks are neither pre-specified nor guaranteed. It is true that some companies pay dividends, and that these dividends are sticky, but it is also true that companies are under no contractual obligation to continue paying those same dividends. This difficulty in observing the equity risk premium leads many to look backwards, when asked to estimate the equity risk premium. Put simply they look at a long time period in the past (50 years or even 100 years) and look at the premium that stocks earned over a risk free investment (treasury bills or bonds); that historical risk premium then gets used as a measure of the current equity risk premium. On my website, I update this historical risk premium every year, and the graph below reflects my January 2021 findings:

Download spreadsheet with raw data

Looking over a 92-year time period (1928-2020), for instance, stocks earned an geometric average return of 9.79%, giving them a premium of 4.84% over the 4.95% that you would have earned, investing in treasury bonds. If you buy into this measure of equity risk premiums, consider its limitations. First, it is backward looking and built on the presumption that the future will look like the past. Second, even if you trust mean reversion, note that the estimated premium is not a fact but an estimate, with a wide range around it. Specifically, the estimate of 4.84% for the equity risk premium from 1928 to 2020 comes with a standard error of 2.1%; the true ERP, with this error, could fall anywhere from 0.64% to 9.04%. Third, this premium is static and does not reflect market crises and investor fears; thus, the historical risk premium on February 14, 2020 would have very similar to the historical risk premium on March 20, 2020.

The alternative approach to estimating equity risk premiums is revolutionary and it borrows from the yield to maturity approach that we used to estimate bond default spreads. Consider replacing the bond price with the level of stock prices today (say, with the S&P 500 index) and coupons with expected cash flows on stocks (from dividends and buybacks), and solve for an internal rate of return:

Implied Equity Risk Premium: In General

The internal rate of return is the expected return on stocks, and netting out the risk free rate today will yield an implied equity risk premium. In the picture below, I use this process to estimate an equity risk premium of 4.72%  for the S&P 500 on January 1, 2021:

Download spreadsheet to compute ERP

It is true that my estimates of earnings and cash flows in the future are driving my premium, and that the premium will be lower (higher) if I have under (over) estimated those numbers. This approach to estimating equity risk premiums is forward-looking and dynamic, changing as the market price changes. In the graph below, I report implied equity risk premiums that I computed, by day, during 2020, in an effort to gauge how the crisis was playing out and keep my sanity.

Download spreadsheet with data

As with the bond default spread, the implied equity risk premium was extraordinarily volatile in 2020, peaking at 7.75% on March 20, before falling back to pre-crisis levels by the end of the year.

Market Gauge?

As we are engulfed by talk of market bubbles and corrections, it is worth nothing that any question about the overall market can really be reframed as a question about the implied equity risk premium. If you believe that the current implied equity risk premium is too low, you are in effect also saying that stocks are overvalued, just as a judgment that the equity risk premium is too high is equivalent to arguing that stocks are undervalued. So, at 4.72%, is the equity risk premium too low and is the market in a bubble? One way to pass judgment is to compare the current premium to implied equity risk premiums in the past:

Download spreadsheet with historical ERP

On this comparison, stocks don't look significantly over valued, since the current premium is higher than the long term average (4.21%), though if you compare it to the equity risk premium in the last decade (5.53%), it looks low, and that stocks are over valued by about 15%. There is a caveat, though, which is that this risk premium is being earned on a risk free rate that is historically low. Consider this alternative graph, where I look at the expected return on stocks (risk free rate plus implied equity risk premium) over the same time period:

For much of this century, the expected return on stocks has hovered around 8%, but the expected return at the start of 2021 is only 5.65%, well below the expected returns in prior periods.

A Market Assessment

I know that you are probably incredibly confused, and I am afraid that I cannot clear up all of that confusion, but this framework lends itself to valuing the entire market. To do this, you have to be willing to make estimates of:

1. Earnings on the index: You cannot value a market based upon last year's earnings (though many do so). Investing is about the future, and uncomfortable as it may make you feel, you have to make estimates for the future. With an index like the S&P 500, you can outsource these estimates at least for the near years, by looking at consensus forecasts from analysts tracking the index.
2. Cash returned, relative to earnings: Since it is cash returned to stockholders that drives value, you also have to make judgments on what percent of earnings will be returned to stockholders, either in dividends or buybacks. To this, you can look to history, but recognize that it is also a function of the confidence that companies have about the future, with more confidence leading to higher cash being returned.
3. Risk free rates over time: While it is generally not a good idea to play interest rate forecaster, we are in unusual times, with rates close to all time lows. In addition, your views on future growth in the economy are intertwined with what will happen to risk free rates, with stronger economic growth putting more upward pressure on rates.
4. An acceptable ERP: As I noted in the last section, equity risk premiums have been volatile over time, and particularly so in years in 2020. The equity risk premium, added to the risk free rate, will determine what you need stock returns to be, to break even on a risk-adjusted basis.

It is only fair that I go first. In the picture below, I make my best judgments on each of these dimensions, using consensus estimates of earnings in 2021 and 2022 to get started, but then slowing growth in earnings to match the growth rate in the economy, which I approximate with the risk free rate. On the risk free rate, I assume that rates will rise over time to 2%, and that 5% is a fair ERP, given history. My valuation is below:

Download spreadsheet to value S&P 500

Based upon my inputs, the S&P 500 is over valued by about 12%, certainly not bubble territory, but still richly priced. You may (and should) disagree with my assumptions, and I welcome you to download the spreadsheet and change the inputs. Ultimately though, the judgment you make on the market will be a joint effect of your views on the economy and interest rates in the next few years. The table below summarizes the interplay between economic growth and interest rate assumptions, and the effects on the index value:

Use S&P 500 valuation spreadsheet to assess value effects

As you can see, there are far more bad possible outcomes than good ones, and the only scenario where stocks have significant room to rise is the Goldilocks market, where rates stay low (at close to 1%), while the economy comes back strongly. I know that the possibility of additional economic stimulus may improve the odds for the economy, but can they do so without affecting rates? To buy into that scenario, you have to belief that the Fed has the power to keep rates low, no matter what happens to the economy, and I don't share that faith. 

As many of you who have read my blog posts know, I am a reluctant market timer, but ultimately we all time markets, implicitly or explicitly, the former wooing up in how much of your portfolio is in cash and the latter in more overt acts of either protection or bets on market directions. Going into 2021, I have far more cash in my portfolio than I usually do, and for the first time in a long, long time, I have bought partial protection against a market drop, using derivatives. It is insurance, and like all insurance, my best case scenario is that I never need to use it, but it reflects my wariness about what comes next. I am not and don't want to be in the business of doling out investment advice, and I think that the healthiest pathway for you is to make your own judgments on interest rates, earnings growth and acceptable risk premiums, and follow that with consistent actions. 

YouTube Video

Spreadsheets

1. Implied ERP for the S&P 500: January 1, 2021
2. Spreadsheet to value the S&P 500 on January 1, 2021

Data Updates for 2021

1. Data Update 1 for 2021: A (Data) Look Back at a Most Forgettable Year!
2. Data Update 2 for 2021: The Price of Risk!
3. Data Update 3 for 2021: Currencies, Commodities, Collectibles and Cryptos!
4. Data Update 4 for 2021: The Hurdle Rate Question

Data Update 3 for 2020: The Price of Risk!

When investing, risk is a given and if you choose to avoid it, at any cost, you will and in the last decade, you have borne a staggering cost in terms of returns unearned. At the other extreme, seeking out risk for the sake of taking risk is more suited to casinos than to financial markets, and as in casinos, the end game is almost always disastrous. The middle ground on risk is to accept that it is part and parcel of investing, to try to gauge how exposed you are to it and to make sure that your expected return is high enough to compensate you for taking that risk. Put simply, you are charging a price to take risk, and that price will reflect not only your history and experiences as an investor, but how risk averse you are, as an individual. In this post, rather than focus on your or my price of risk. I want to talk about the market price of risk, as assessed by all investors, and how that price changed in 2019.

The Price of Risk
There are almost as many definitions of risk, as there are investors, but I find many of them wanting. There is, of course, the definition of risk as uncertainty, a circular play on words, since it just replaces one nebulous word (risk) with another. There is the definition of risk as encompassing all the bad outcomes you can have on an investment, which by making risk into a negative and something to be avoided, leads you right into the arms of those selling your protection against it (in the form of hedging). In finance, we have become so used to measuring risk in statistical terms (standard deviation, variance, covariance etc.) that we have taken to defining risk with these measures, an arid and antiseptic view of risk.  The truth is that risk, at least in business, is neither a good nor a bad, but a given. It is a combination of danger (the likelihood that bad things will happen to you) and opportunity (often emerging from exposing yourself to danger, and I think that the Chinese symbol for crisis captures its essence perfectly:

(I know! I know! I have been corrected and recorrected on both the symbols and the definition by people who know far more Chinese than I do, which is pretty much everyone in the world… So, please cut me some slack!) It is this definition of risk that allows us to frame the risk/return trade off that lies at the heart of investing. While you can choose a pathway of taking no risk and earning guaranteed returns, those returns in today’s markets would be close to zero in the United States and Europe. If you want to earn higher returns, you have no choice but to expose yourself to risk, and when you do, the key question becomes whether you are being compensated sufficiently for taking that risk. 

• When you invest in fixed income securities (bonds), your compensation takes the form of a default spread, i.e., what you charge over and above the risk free rate to invest in that bond.
• · When you invest in equities, the payoff to taking risk comes in the form of an equity risk premium, i.e., the premium you demand over and above the risk free rate for investing in equities as an asset class.

Both the default spread and the equity risk premium are market-set numbers and are driven by demand and supply. The default spread is a function of what investors believe is the likelihood that borrowers will fail to make their contractually obligated payments, and it will rise and fall with the economy. The equity risk premium is a more complex number and I think of it as the receptacle for everything from changes in investor risk aversion to perceptions of economic growth and stability to corporate choices on leverage and cash return to global flash points (war, health scares etc.).

The Default Spread

The default spread is the premium that investors demand on a bond to compensate for default risk, and not surprisingly, it varies across bond issuers, with safer (riskier) borrowers being charged less (more) to borrow money. One assessment of corporate default risk is a bond rating, a measure of default risk computed by ratings agencies. While ratings agencies have been criticized for bias and delay, these bond ratings are still widely used, and are a convenient proxy not only for measuring default risk, but also for estimating default spreads. In the graph below, I have listed the default spreads at the start of 2020 and compared them to default spreads that I had estimated at the start of 2019, by ratings class:

Source: Damodaran Online

The first conclusion, and a completely unsurprising one, is that companies that are lower rated (and thus perceived to have more default risk) have larger default spreads than companies that are highly rated; a BBB (Baa) rated bond, at the cusp of investment grade and junk bonds, for instance, saw its default spread drop from 2.00% at the start of 2019 to 1.56% at the start of 2020. To get some longer-term perspective on how much default spreads change over time, the default spread on the investment grade (BBB, Baa) rated bond is graphed below from 1980 to 2019:

Source: FRED (Federal Reserve St. Louis)

At the risk of stating the obvious, the default spreads on bonds change over time, decreasing when times are good and investors are sanguine, and increasing during economic downturns and market crises.

The US Equity Risk Premium

In my last data update post, where I looked at markets over the last decade, I also posted a table that reported historical equity risk premiums, i.e., the premiums earned by stocks over treasury bills and bonds over long periods, ranging from a decade to 92 years. 

Source: Damodaran Online

There are many practitioners, who use these historical equity risk premiums as the best estimates for what you will earn in the future, using mean reversion as their basic argument. I have already made clear my problems with using a backward-looking number with a large estimation error (see the standard errors in the table above) as an expectation for the future, but it cuts against the very essence of an equity risk premium as a number that should be dynamic and constantly changing, as new information comes into markets. For almost three decades, I have computed an implied equity risk premium, a forward-looking value computed by looking at what investors are paying for stocks today, and the expected cash flows on those stocks. Specifically, I take an approach that is used with bonds to compute a yield to maturity to stocks, computing an IRR for stocks and then subtracting out the risk free rate. At the start of 2020, the implied equity risk premium for the S&P 500 was 5.20% and the calculations are in the graph below:

Download spreadsheet

Since I have been computing this number at the start of each month, since September 2008, I can look at how this number moved in the twelve months of 2019:

Damodaran Online

During the course of the year, the implied equity risk premium has decreased from 5.96% to 5.20%, driven down by increasing stock prices and lower interest rates.

I am fascinated by the implied equity risk premium because it captures the market’s current standing in one number and frames debates about the overall market. A contention that markets are overvalued, or in a bubble, is equivalent to claiming that the equity risk premium is too low, relative to what you believe is a reasonable value. In contrast, a bullish assessment of the entire equity market can be viewed as a statement about equity risk premiums being too high, again relative to reasonable values. But what is a reasonable value? I have no idea, since I am not a market timer, but to help you make your own assessment, I have reproduced the implied equity risk premium for the S&P 500 going back to 1960:

Download spreadsheet

You could use the computed averages embedded in the graph as your basis for reasonable, and using that comparison, the market looks closer to under than overpriced, since the ERP on January 1, 2020 was 5.20%, higher than the average for the last 60 years (4.20%) or the last 20 years (4.86%). Even with a 10-year average, the market is only very mildly overpriced. It is true that the current implied ERP of 5.20% is being earned on a riskfree rate of 1.92%, low by historical standards, yielding an expected return of 7.12% and that may be too low for some. I will let you make your own assessment, but this is a healthier one that just looking at PE ratios (Shiller, trailing, forward) or other market metrics.

A Real Estate Risk Premium?

If default spreads measure the price of risk in bond markets and equity risk premiums measure the risk for investing in stocks, what is the price of risk of investing in other asset classes? It may be more difficult to assess what this value is in other risky markets, but it exists without a doubt, and one way of evaluating how much of your portfolio to allocate to these asset classes is to compare their risk premiums to the risk premiums of bonds and stocks. To get a sense of how this would play out, consider the real estate market, perhaps the biggest asset class outside of stocks and bonds. Investors in commercial real estate attach prices to properties, based upon their expectations of income from the properties and capitalization rates. Thus, a property with expected income of $10 million and a capitalization rate of 8% will be valued at $125 million = $10/.08. Since the capitalization rate is effectively a measure of expected return on real estate, subtracting out the risk free rate should yield a measure of the risk premium in real estate. 

Risk Premium for Real Estate = Cap Rate – Risk free rate

In the graph below, I have estimated the real estate risk premium and provided a comparison to the equity risk premium and default spread, over time:

Note that the real estate risk premium in the 1980s was not only well below the equity risk premium and the default spread, it was sometimes negative. While that may strike you as odd, it makes sense if you think of real estate as an asset class that is not only uncorrelated with financial asset returns but also provides insurance against inflation. As real estate was securitized in the 1990s and fears of inflation receded, the real estate risk premium has started behaving like the risk premiums in stock and bond markets, and the rising correlation between them reflects that co-movement. Put simply, we live in a world, where the real estate you own (often your house or apartment) will tend to move with, rather than against, your financial assets, and in the next market crisis, as the stocks and bonds that you own plummet in value, you should expect the value of your house to drop as well!

Conclusion

The debate about equity risk premiums is not an abstract one, since which side of the debate you come down upon (whether risk premiums today are too high or low) is going to drive your asset allocation judgments. If you are a bear, you believe that equity risk premiums should be higher, either for fundamental reasons or by instinct, and you should put less of your wealth into stocks than you normally would, given your age, liquidity needs and risk aversion. The challenge that you will face is in deciding where you will invest your money until you think that the ERP becomes more reasonable, since bonds are likely to also be overpriced (according to your view of the world) and real assets will often be no better. If you are a market bull, your story has to be one of equity risk premiums declining in the future, perhaps because you believe in your own version of mean reversion or because of continued economic growth. For both market bulls and bears, the perils with bringing these views into every valuation that they do is that every company they value will then jointly both their views about the company and the overall market. It is for this reason that I think it makes sense to revert back to a market neutral view, when valuing individual companies, even if you have strong market views. Since my market timing skills are non-existent, I prefer to stay market neutral, and stick to valuing companies using the prevailing equity risk premiums. 

YouTube Video

Spreadsheets

1. Implied Equity Risk Premium on January 1, 2020

Datasets

1. Historical Equity Risk Premiums for the US - 1960 to 2019
2. Historical Default Spreads on Baa Rated Bond - 1980 to 2019
3. Default Spreads on Bond Ratings Classes (my estimates) in January 2020

Data Update Posts

1. Data Update 1 for 2020: Setting the Table
2. Data Update 2 for 2020: Retrospective on a Disruptive Decade
3. Data Update 3 for 2020: The Price of Risk!

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