I frequently get asked about the merits of corporate bonds, both investment-grade (IG) and high-yield (HY), relative to government and municipal bonds. I don’t believe the risk-return profile for long-term investors (particularly taxable individual investors) is improved by owning IG or HY corporate bonds compared with simply owning a diversified portfolio of stocks and high-quality government bonds.

The key here is to understand that corporate bonds are essentially nothing more than a combination of stock market risk and interest rate risk. What this means is that instead of owning a portfolio that is allocated 60 percent to stocks and 40 percent to IG corporate bonds, you could instead allocate, say, 65 percent to stocks and 35 percent to government bonds and end up with roughly the same risk-return profile. However, the second portfolio would be more tax efficient because stocks receive long-term capital gains treatment while bonds are taxed at ordinary income rates. Further, the second portfolio might be even more advantageous if you’re subject to high federal income tax rates and all or most of your investment assets are in taxable accounts. In that case, you could choose to own municipal bonds, which are significantly more tax efficient than corporate bonds.

Diving Into the Data

Let’s stick, though, with a comparison of pretax returns and risk because I first need to show that corporate bonds don’t improve these results. If this can be illustrated, it’s hard to argue that portfolios with more in corporate bonds and less in stocks and municipals are more tax efficient. In the first table, the performance characteristics of a 60/40 portfolio, where the 40 percent in fixed income is allocated entirely to IG corporate bonds, is compared with a portfolio that can use only Treasury bonds for fixed income but can adjust the equity and fixed income mix to achieve similar volatility to the first portfolio. In all cases, the equity allocation is split between S&P 500 (two-thirds) and MSCI EAFE (one-third).
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As you can see, the performance results are virtually identical over the period of 1984-2013 (the longest period for which I had data). If anything, you might give a slight edge to the second portfolio because it performed quite a bit better in 2008 (likely showing that the correlation of corporate bonds and stocks tends to escalate in chaotic market environments). Notice that having 40 percent in IG corporate bonds is basically the same as having 33 percent allocated to Treasury bonds and 7 percent in stocks.

Now let’s examine HY corporate bonds.

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Here, we see similar results. The risk-return characteristics are virtually identical between the two portfolios. Note, though, that having 40 percent in HY corporate bonds is roughly equivalent to having 15 percent allocated to Treasury bonds and 25 percent in stocks! This shows that HY corporate bonds behave more like stocks than high-quality fixed income. Given the results in these two tables and the better tax efficiency of the second portfolio in both examples, it’s difficult to build a case for including corporate bonds in a portfolio.

Jared Kizer is the director of investment strategy for the BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.