Last week, I outlined how to construct a portfolio of stocks and high-quality bonds to replicate the returns of high-yield corporate bonds. This week I’m tackling investment-grade corporate bonds.The same basic logic as last week holds: There’s not much unique about investment-grade corporate bonds that you can’t achieve with a diversified portfolio of stocks and high-quality bonds. The only difference is you don’t need as much in stocks to replicate the returns of investment-grade corporate bonds as you do with high-yield corporate bonds. This is because high-yield corporate bonds are more similar to stocks because they both have substantial exposure to default risk. Investment-grade corporate bonds have less default risk and therefore aren’t as similar to stocks.
With interest rates at low levels for a number of years now, many investors have moved some portion of their high-quality bond portfolios to higher-yielding investments like high-yield corporate bonds. I’ve long argued that there’s not much these strategies add relative to a traditional stock fund and high-quality bond strategy. Further, the traditional stock fund and high-quality bond allocation strategy tends to have lower costs and be more tax efficient. This is a bit of a qualitative argument though, and I wanted to illustrate the point quantitatively.