Can Bonds Continue to Outperform?

Bonds have outperformed stocks by a large margin over the past year because of the financial crisis, and they’ve also roughly matched stocks over the past 40 years.

But Peng Chen and Roger Ibbotson of Morningstar show in a recent report that stock returns over the last 40 years were in line with the long-term historical average. Bond returns, though, were much higher than their historical averages and their current yields. This high bond return, the researchers explain, stems from higher interest rates in the 1970s and a subsequent declining interest rate environment. Such a scenario for bonds is very unlikely to repeat itself in the future, given today’s low interest rate environment.

Their conclusion: “Investors hoping bonds will outperform in the coming years will likely be disappointed,” they say.

Bonds can outperform stocks over a long period, Chen and Ibbotson add, but investors need almost perfect timing to get in and out of the market to realize such returns. “We believe the right strategy is to follow a disciplined asset-allocation policy that considers the return and risk tradeoffs by taking advantage of the diversification benefits between stocks and bonds over time,” they conclude.