## **Learning Outcomes**

This article explains how to analyze asset class return expectations for equities, sovereign bonds, and credit instruments in a CFA Level 3 exam setting. It develops the ability to decompose expected returns into real risk‑free rate, expected inflation, and key premia (equity, term, credit, and liquidity), and to interpret how each component responds to changes in macro conditions and market sentiment. The article clarifies the definitions, intuition, and exam‑relevant implications of the equity risk premium and credit risk premium, including drivers, cross‑country variation, and cyclical behavior. It also explains how major risk factors—market, duration, credit spread, and other style or liquidity factors—map into asset class performance and required compensation. The article then demonstrates how to implement the main estimation approaches used in the curriculum (historical averages, building‑block/forward‑looking models, and risk‑factor or narrative frameworks), and how to apply them to equities, government bonds, and spread products. Finally, the article emphasizes practical strengths, weaknesses, and typical exam traps when forming, interpreting, and comparing asset class expectations in institutional portfolio management contexts.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand how asset class return expectations for equities, bonds, and credit spread products are formed, the relevant risk premia, and the assessment tools used, with a focus on the following syllabus points:

- Explaining the fundamental sources of expected returns for equities and bonds
- Describing the equity risk premium, term premium, and credit risk premium
- Identifying main risk factors that drive asset class return differences
- Applying methods used to estimate and interpret expected returns in an institutional context
- Recognizing limitations, risks, and practical considerations for asset class forecasts

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the equity risk premium and what are some factors that could cause it to vary between markets or over time?
2. Define the term credit risk premium. What are its principal components?
3. Why does the term premium on bonds tend to increase with maturity, and which macroeconomic factors most strongly influence it?
4. State one method a CFA candidate might use to estimate the expected return of an equity index or credit asset class for an exam scenario.

## **Introduction**

Predicting long-run returns for asset classes is central to institutional portfolio management. Expected returns for equities, bonds, and spread products such as credit are grounded in economic fundamentals—real risk-free rates, term premia, and the additional returns required by investors for taking on major risks. An understanding of these expected return sources and the component premia (such as the equity risk premium and credit risk premium) is critical for setting portfolio strategy, asset allocation, and risk management. This article details the key concepts CFA Level 3 exam candidates must understand thoroughly, explains risk factors, and presents common estimation approaches.

> **Key Term: asset class expectations**
> The forecasts of long-run risk and return for broad groups of similar securities, such as equities, sovereign bonds, and credit.
>
> **Key Term: risk premium**
> The expected excess return above a risk-free benchmark, provided as compensation for taking on a specific risk (such as equity, credit, duration, or liquidity).

## **The Building Blocks of Expected Asset Class Returns**

### Equities

The prospective return to equities can be viewed as the sum of several identifiable components:

- A real risk-free rate (the expected real yield on ultra-safe short-term assets)
- Expected inflation over the holding period
- The equity risk premium (return in excess of risk-free, compensating for uncertain corporate profits, default, and market-wide risks)

The equity risk premium (ERP) is central: it is the required expected additional return for investing in stocks instead of riskless assets. It is driven by uncertainty around future profits and economic shocks. ERP is not static—levels may rise in periods of risk aversion and fall in boom times.

> **Key Term: equity risk premium**
> The amount by which the expected return of equities exceeds that of risk-free securities, compensating investors for exposure to company and macroeconomic risk.

### Bonds

Bond expected returns are also decomposable:

- Real risk-free rate (applies to default-free, liquid short-term bonds)
- Expected inflation (for nominal bonds)
- Term premium (for longer-maturity bonds relative to short-term instruments)
- Credit risk premium (for bonds exposed to possible default—see below)
- Liquidity premium (for bonds with high transaction costs or risk of forced sale at adverse prices)

The “term premium” reflects the risk of holding longer-duration bonds and is typically positive due to greater sensitivity to unexpected interest rate changes.

> **Key Term: term premium**
> The expected return compensation for holding longer-maturity (higher-duration) bonds subject to greater price volatility from interest rate fluctuations.

### Credit Products

For bonds and spread assets with credit risk (corporate, sovereign, etc.), the expected return comprises:

- Real risk-free rate
- Expected inflation (if nominal bonds)
- Term premium (if applicable)
- Credit risk premium (to compensate for the probability of default and/or rating downgrade)
- Liquidity premium (especially for less-traded credits)

The credit risk premium (CRP) is sometimes split into expected loss (loss given default times probability of default) and “excess spread” (premium for uncertainty around credit losses, downgrades, and the risk of rapid “spread widening”).

> **Key Term: credit risk premium**
> The part of a credit asset’s expected return in excess of a comparable risk-free bond, compensating for uncertainty about default, downgrade, and loss severity.

## **Risk Factor Approach to Asset Class Expectations**

CFA exam candidates must be able to relate asset class returns to key risk factors:

- **Market factor (systematic or market beta):** Most equities’ returns are heavily linked to broader market returns.
- **Term (duration) factor:** Longer-term bonds are more price sensitive to rate shifts, leading to a term premium.
- **Credit/spread factor:** Riskier credits (lower rating or riskier sector) require additional expected return.
- **Other factors:** Size, value, momentum, liquidity can also matter for equities or certain credit indexes in active management or factor investing contexts.

Risk premia arise because investors require compensation for exposure to factors outside their control—unanticipated changes in economic/policy regimes, credit events, sharp swings in liquidity or sentiment, etc.

### Relationship to Macro Environment and Structure

Premia levels change as the economic cycle shifts, central bank policy alters, or the financial system’s risk tolerance evolves. For example, a rise in monetary policy uncertainty typically lifts the term premium.

Elevated ERP is often seen after crises or in markets with less developed institutions, whereas mature, transparent markets may have a structurally lower ERP (but with less dispersion).

## **Estimating Asset Class Expected Returns**

There are three principal approaches:

### 1. Historical Average Approach

Use long-run historical data as the best estimate—but adjust for known regime shifts, sample bias, or changes in risk.

- For equities: Estimate ERP as average equity returns less average bond yield, using as long a time series as available.
- For bonds: Use average past term spreads.

### 2. Building Block/Forward-Looking Models

Break return down into components (e.g., dividend yield, trend earnings growth, ERP, expected inflation), forecast each, and sum for the anticipated mean return.

- For bonds, sum risk-free rate, term, expected inflation, and applicable risk premia.
- For credit assets, build from base government yield plus modeled credit spread based on default rates, recovery, downgrade probabilities, and market-implied risk aversion.

### 3. Risk Factor Model/Narrative Analysis

Estimate expected return as compensation for specific risk factors, using economic theory or empirical data. Examples:

- The expected return for a high-yield bond is the risk-free rate plus term, credit, and liquidity risk premia, each estimated using economic and forward market data.
- For an equity portfolio, the expected return could be the risk-free rate plus the appropriate ERP, with sector-specific adjustments for style or country factors as required.

### **Worked Example 1.1**

A US pension fund wants an expected average annual return estimate for domestic equities over a 10-year horizon, using a building block approach. The current real risk-free rate is 1%. Forecast inflation is 2.5%. The current dividend yield is 2%, with anticipated real earnings growth per year of 1.5%. The forecast ERP over bonds is 3.5%.

> **Answer:**
> Expected annual equity return = Real risk-free rate + Inflation + Dividend yield + Real growth + ERP  
> = 1% + 2.5% + 2% + 1.5% + 3.5% = 10.5%.  
> However, careful candidates will recognize that overlapping components (such as growth reflected in the ERP) may require adjustments to avoid double-counting.

### **Worked Example 1.2**

A global manager wants to estimate the spread required to hold a 5-year BBB-rated bond when the base government yield is 2%, historical average default loss is 0.45% p.a., and market-implied excess spread is 0.55% for “premium” risk compensation.

> **Answer:**
> Total credit spread = Expected loss due to default + excess premium = 0.45% + 0.55% = 1.00%
> Required yield = 2% + 1.00% = 3.00%

## **Summary**

Asset class expectations for equities, bonds, and credit are structured around compensation for fundamental risks. Equities demand an equity risk premium above the risk-free rate, which fluctuates with economic and institutional factors. Bonds offer a term premium for duration, and credit assets carry a premium on top for default and liquidity risk. Asset class return estimates can be formed by historical, building block, or factor model approaches, all requiring reasoned economic judgment. Accurate expectations are critical for institutional investors building robust portfolios on the CFA exam.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Describe and explain return components for equities, bonds, and credit asset classes
- Define and interpret the equity, term, and credit risk premia for CFA Level 3
- Recognize key risk factors influencing asset class returns
- Identify the main approaches to estimating expected returns for institutional portfolios
- Understand the application and limitations of ERP and risk premia for portfolio management

## **Key Terms and Concepts**

- asset class expectations
- risk premium
- equity risk premium
- term premium
- credit risk premium

Asset class expectations - Equities bonds and credit risk premia