Should you go with bonds? Or are shares offering enough of a risk premium?
What is “equity risk premium”, or ERP, and is it enough? In this article we’ll explore both these questions, plus have a look at three factors that create confusion around the ERP concept, and why the prospective return differential that shares offer over bonds today is far more attractive than it was at the height of the last bull market in 2007.
Introduction
ERP is the additional return that stocks (either individually or the overall stock market) provide over ”risk-free” assets, such as government bonds. (Of course, while no investments are truly “risk free”, government bonds tend to be seen as such because of the low chance a government will default on its loans.)
Basically, ERP refers to a trade off in the vein of “the higher the risk, the higher the return”. Shares are riskier than government bonds, so you can expect to be compensated with a higher return.
Sometimes also just called an “equity premium”, its size varies with the risk of a particular stock, or even of the market as a whole.
Generally, it’s usually thought shares should return 5-7% per annum over bonds. Basically because this is what their excess return has been over much of the post-war period; however, this probably exaggerates the required excess return for shares.
The recent bear market has caused shares to struggle (for the past 10 years) compared with bonds. But don’t interpret this as meaning shares are a dud investment, nor that the ERP concept is meaningless.
Shares versus bonds
Dr Shane Oliver, head of Investment Strategy and the Chief Economist with AMP Capital Investors, says shares have a greater short-term volatility and risk of loss compared with “risk free” government bonds, so shares should offer a return differential over the long term.
While this return differential, or ERP, has been around 5-7% per annum for much of the post war period, the recent bear market has caused US shares to underperform US bonds by 7% pa over the past decade, yet Australian shares have outperformed bonds - but by just 2% pa.
Does this mean shares are a dud investment? And the equity risk premium concept is meaningless? The answer to both is no.
The key is looking forward
The ERP concept relates to the long term, so the bear market of the past two years proves nothing about ERP’s merits.
Confusion surrounds ERP due mainly to three different things:
- the historically realised return gap between equities and bonds
- the gap investors need to attract them to invest in equities, and
- the likely long-term gap, based on current valuations
The key issue is not what equities have done relative to bonds in the past but what their potential is in the future, and, says Dr Oliver, experience informs us these two concepts can move in opposite directions.
Let’s look at the three factors.
1. The historical (or “ex post”) ERP
Many analysts tend to focus on historical data as a guide to what sort of return premium that investors need for shares over bonds, and what it will be in future.
However, says Dr Oliver, although a useful starting point, this approach has limitations.
Firstly, the historically realised return differential between equities and bonds varies significantly over time. For instance, between 1950-1999, the ERP was 7.5% pa in the US, but if the period is extended to 2008 the ERP falls to 4.4% pa. Similarly, the realised ERP for Australian shares was 5.6% pa over 50 years from 1950, but if the period is extended to 2008 it drops to 4.6% pa.
Examining rolling 10-year periods highlights the instability of realised ERP, with the excess return from shares over bonds varying from around:
- -10% to +20% pa in the US and
- -7% to +17% pa in Australia
So the past decade’s negative or low-equity risk premium is not unusual in an historic context. It is interesting to note there is a degree of mean reversion, with decades of low excess returns from shares being followed by decades of high returns, and vice versa.
All of this means that the poor performance of shares versus bonds over the past decade actually suggests shares have a good chance of outperforming bonds in the coming decade.
Naturally, the starting and end-point valuations for markets (for any period) heavily affects the size of the realised risk premium – even over long periods. For example over the 50 years from 1950, bond returns were pushed down by the fact that in 1950, bond yields were low (around 2% in the US and 3% in Australia), and so bonds suffered capital losses as yields were much higher in 1999.
In contrast, equity returns were boosted by the fact that shares were depressed relative to earnings in 1950 (in the aftermath of the Great Depression and WWII); so they generated strong capital gains over the next 50 years as share prices rose relative to earnings. As a result over the 1950 to 1999 period, shares outperformed bonds by a very wide margin. However, if you change the end point to the end of 2008, the recent bear market has greatly reduced the return from shares, and bond yields had fallen sharply, boosting the measured returns from bonds.
The point is, says Dr Oliver, that even when measuring over long periods, the starting and end points have a big impact on the measured ERP.
Secondly, to the extent that valuation changes (rising bond yields and rising price-to-earnings multiples) boosted the realised ERP over the post-war period, investors would not have expected this and hence the measured ERP over that period is not a good guide as to what they would have required to invest in shares.
Thirdly, it is difficult to justify why investors would have demanded such a large premium (i.e., 5-7% pa over the 50 years from 1950). This would imply an implausibly high degree of risk aversion.
Finally, historical equity data for countries such as the US and Australia suffers from a survival bias. An investor who bought into German and Japanese shares in 1900 would have been wiped out along the way.
For these reasons, while analysing the past is a good starting point it is not a definitive guide as to what the ERP should be, or will be.
2. Required ERP
We have already noted that historically realised ERP is not a good guide as to what investors actually need to invest in shares. For instance, the 5-7% ERP achieved in much of the post-war period was largely due to a windfall gain to equity that investors neither expected nor needed to make that investment.
Several considerations suggest the required ERP has fallen and is now well below this, including:
- the inflation drop that has probably resulted in a higher quality of earnings and reduced economic uncertainty;
- a greater feeling of global political security (no world wars in 60 years, plus the end of the Cold War);
- improved regulatory and legal protection for investors;
- lower trading costs in equities, greater scope to spread risk via diversification and improved market liquidity; and
- increased demand for shares from pension funds helped by tax concessions on retirement savings.
Dr Oliver says while the “war or terror” and the global financial crisis may have partly offset some of these favourable factors, the broad trend is still positive and suggests investors should demand a lower risk premium than, say, 50 years ago.
He believes the appropriate ERP for US and world equities is close to 3%. For Australian shares, fewer opportunities for diversification justify a slightly higher premium of around 3.5%, and for Asian shares greater economic and market volatility suggest a required ERP of around 4%.
However, he says, while this is his assessment for the required return differential for equities over bonds, what will actually be delivered is a different matter.
3. The prospective (or “ex ante”) ERP
A simple way to think of the likely ERP for the next five to 10 years (at any time) is this:
Likely ERP = Dividend Yield + Growth Rate – Bond Yield
“Growth rate” is that in share prices, which is assumed to equal the long-run growth rate in listed company earnings. This, in turn, is assumed to equal long-term nominal growth in the economy.
This approach makes intuitive sense because the return on shares equals dividend income plus capital growth.
Dr Oliver says analysing dividend yields, growth and 10-year bond yields to get the likely ERP and required ERP for the next five to 10 years through world markets, suggests that likely ERPs for shares are now well above what we think is required - and that’s particularly the case for Asian shares.
Because of the share slump since 2007, which boosted dividend yields and the fall in bond yields, the ERP estimates are far more attractive than was the case in 2007 when the last cyclical bull market peaked, bond yields were much higher and Australia offered a prospective ERP of 3.6% and the US 2.5%.
Dr Oliver says the calculation above of the prospective risk premium assumes that bond yields are unchanged. In fact, the risk over the next few years is that bond yields will rise towards more normal levels as central banks raise interest rates and inflation picks up. This, he says will result in capital losses on government-bond investments and hence a potentially higher excess return from shares over bonds.
Conclusion
History does not provide a definitive guide of the ERP shares should - or will - offer over bonds. Just as the recent experience of a negative excess return understates the return from shares over bonds, longer-term perceptions of a 5-7% pa return excess exaggerate it.
Many factors suggest the required ERP is somewhere around 3-4% pa, but current estimates suggest the likely ERP is now above this level – particularly for Asian and Australian shares. The prospective return differential that stocks offer over bonds today is far more attractive than it was at the height of the last bull market in 2007.
While stocks are vulnerable to a correction after their sharp gains from March, their attractive risk premium compared with bonds suggests that any short-term pullback in shares will simply be a correction in a still rising trend.
Sources: Investopedia and “Are shares offering enough of a risk premium over bonds?”, by Dr Shane Oliver Head of Investment Strategy and Chief Economist, AMP Capital Investors.
Tags: bonds and equities, equity premium, ERP