Bonds in the U.S. and other major markets around the world likely won't deliver the same high performance in the future as they have in the recent past, according to an annual report by the London Business School and Credit Suisse.
The annualized real return for the 11 years ended Dec. 31 for U.S. bonds was 5.4%, compared with -1.2% for stocks, according to the Credit Suisse Global Investment Returns Sourcebook 2011, written by London Business School finance professors Elroy Dimson, Paul Marsh and Mike Staunton.
The average annualized returns for the 19 countries in the authors' worldwide sample were 5.4% for bonds and -0.4% for stocks.
In fact, for the 40 years ended Dec. 31, 2008, bonds returned an average annualized 4.18% in the U.S., outperforming stocks by two basis points. In the same period, world bonds returned 4.77% on average, topping stocks by 76 basis points. And, the authors pointed out, this outperformance occurred despite the fact that stocks carry more risk.
“Bonds have been stellar performers throughout the working lives of most individuals,” the report said.
But the authors warn that expecting similar returns in the future “would be fantasy,” as bond outperformance has “arisen from non-repeatable factors, and future returns are likely to be far lower.”
The authors will delve into bond returns in detail Feb. 28 when they release their annual Global Investment Returns Yearbook report, Mr. Marsh said.
Meanwhile, since 2000, U.S. equities have underperformed cash by 130 basis points in average annualized returns. That's compared with long-term outperformance of 530 basis points over cash.
Worldwide stock returns trailed cash by 50 basis points in the most recent 11-year period while topping cash by 450 basis points on average each year since 1900.
“This has been a pretty dismal period for equity, despite the wonderful returns” since March 2009, Mr. Marsh said at a Feb. 7 news conference in London.
In the 111 years ended Dec. 31, U.S. equities returned an average annualized 6.3% vs. 1.8% for bonds. Worldwide figures showed a similar pattern, with stocks returning 5.5% vs. 1.6% for bonds. Cash returned 1% for the period.
The authors have reviewed long-term returns annually since publishing their book, “Triumph of the Optimists,” in 2002. A long-term perspective is required to understand risk and return because investments — especially stocks — are so volatile, according to the most recent Sourcebook report.
But the authors warn that decades-long periods that seem long term can still be misleading because of the time-varying nature of the equity risk premium and, simply, bad or good luck.
“At the end of 1999, investors cannot have expected, let alone required, a negative risk premium from equities, otherwise they would simply have avoided them,” the report said. “Looking in isolation to the 11 years that followed tells us nothing about the future expected risk premium from equities. It just tells us that investors were unlucky and experienced two savage bear markets.”
Despite the dreadful equity returns of the past 11-year period, the previous decade (1990-1999) was a “golden age,” where inflation, interest rates and bond yields fell while corporate profits accelerated, the report noted. In that decade, U.S. stocks outperformed cash by 1,230 basis points (vs. a long-run historical average 530 basis points) and bonds bested cash by 380 basis points (vs. a long-run historical average 80 basis points).
Worldwide, equity investors outperformed cash by 600 basis points annually (vs. 450 basis points historically) and bond investors outpaced cash by 470 basis points (vs. 60 historically).
However, even long-run data stretching back to 1990 cannot be expected to accurately predict future returns, the authors said. Investors shouldn't expect that the equity risk premium — or the outperformance of stocks over cash — should remain constant, as it will be affected by dividend growth, the multiples used to price stocks, and changes in real interest rates. For example, dividend yields have fallen since 1900 as investors grew willing to pay more for each unit of dividend risk, something Mr. Marsh explained as a result of portfolios becoming less risky because of diversification.
Looking at the U.S. market's long-run 5.5% average annualized return, Mr. Marsh suggested 50 basis points should be shaved off expected future returns because it is unlikely multiples will continue to expand, another 80 points cut for the “good luck” investors had in the second half of last century, and another 100 basis points from expected higher cash returns. That leaves an expected real equity risk premium of 3.1%.
“That seems to us to be a much more appropriate expectation,” Mr. Marsh said at the news conference, adding that investors could apply their own assumptions to arrive at their own estimates.