Bonds have trumped stocks, but which will win in the future?
The historic bear market of 2008 has shaken a foundational faith of many investors. It has long been believed that stocks offer the best returns over lengthy periods of time.
Instead, the latest statistics show that long-term U.S. government bonds have offered higher nominal returns than stocks over the last 20 years, 10 years, 5 years, and 1 year through June.
Some investors may be kicking themselves for ever investing in stocks and suffering through two major bear markets and one minor bear market over the last 20 years.
Since June 1989 the Standard & Poor’s 500 Index has offered a 7.76 percent annualized return. The Ibbotson and Sinquefield index of long-term government bonds, however, has gained 8.62 percent a year on an annualized basis.
Indeed, government bonds gained 7.55 percent per year over the last 10 years, beating stocks by almost 10 percentage points annually. Stocks lost 26.22 percent over the year ended in June vs. a gain of 7.67 percent for bonds.
The great deflation
The reason bonds did so well is easy to see: interest rates hit their highest peaks of the 20th century back in the early 1980s as the Federal Reserve Board pushed up rates to fight double-digit inflation. Twenty years ago government bonds with 10 years or more to mature yielded 8.2 percent, according to the Federal Reserve Bank of St. Louis.
Since then bond yields have steadily fallen as inflation has declined. As yields on new bonds decreased, older bonds with higher yields commanded higher prices. Thus investors who bought bonds at the peak of the yield cycle 20 years ago have enjoyed capital gains on their investments.
An investor looking at past performance statistics might draw the conclusion that bonds are a better bet than stocks.
No repeats?
That is not very likely, however. Long-term government bond yields today stand at around 3.6 percent, and offer little room for further declines that would lead to capital gains.
Indeed, the president of Ibbotson Associates has warned that investors probably won’t get the returns from bonds that they need to keep up with inflation going forward.
“This is the worst time to put all of your money into bonds, given the low-yield environment,” said Peng Chen upon release of a report by his company on stock and bond returns over the last 40 years.
Ibbotson forecasts that bond returns going forward will average about 3 percent to 4 percent annually. Stocks, which hit bargain levels at the market’s low on March 9 of this year, may have better prospects.
Indeed, through June of this year the S&P 500 gained 3.2 percent since Jan. 1 while long-term government bonds lost 13.7 percent.
Ibbotson’s study showed that the best bet is to avoid a choice between stocks and bonds. Instead, it is better to own both.
It constructed a portfolio of 60 percent stocks and 40 percent bonds and tracked its performance over the last 40 years. It had an average return of 9.1 percent, beating the 8.8 percent return on bonds and the 8.7 percent return on common stocks. The diversified portfolio also offered a more stable return than the stock market over the years.