Stocks vs. High-yield Bonds: Risk-Reward, Taxes?

Question

Assuming one is looking for a fairly high-risk, high-reward investment, what are the advantages and disadvantages of a diversified stock portfolio (e.g. an S&P 500 index fund) vs. a diversifed high-yield (junk) bond portfolio? The most important questions I'm interested in are:

1. Historically and theoretically, how much more/less risky and potentially rewarding are junk bonds compared to stocks? Qualitatively, how do the risks differ? For example, is one asset class more vulnerable to infrequent but large losses while the other is more vulnerable to more frequent but less severe volatility?

2. How strongly is the return in the junk bond market correlated with the return in the stock market over medium and long time horizons? Do stocks and junk bonds have much value in terms of diversifying each other's risks or are they mostly vulnerable to the same risks?

3. Are there any major tax considerations that favor one of these over the other?

Answer 1

1. Historically and theoretically, junk bonds and large cap stocks (e.g., S&P 500) have about the same risk and returns, with stocks probably outperforming over sufficiently long horizons. Although a high-yield fund is always buying new bonds, in theory an individual bond can only go up so far as eventually (in extreme cases) it's credit improves to the point where it trades close to government bonds. An individual bond can also "jump to default" where a significant chunk of money is lost in one shot. A broadly diversified portfolio of junk bonds will behave similarly to the S&P 500.
2. Very strongly correlated. There is not much diversification value. You will get much better diversification mixing stocks with investment grade bonds.
3. Check with your tax accountant for your personal situation, but in general in fully taxable accounts junk bonds will throw off more taxable distributions. Under current law, these are taxable at your marginal income tax rate. The capital appreciation, however, is taxed at a more favorable capital gains rate. Junk bond total returns are generally more tilted towards taxable income distributions than stocks.

Answer 2

When credit locks up, junk bond prices fall rapidly, and you see more defaults. The opportunity to make money with junk is to buy a diversified collection of them when the market declines.

Look at the charts from some of the mutual funds or ETFs like PIMCO High Yield Instl (PHIYX), or Northeast Investors (NTHEX). Very volatile stuff.

Keep in mind that junk bonds are not representative of the economy as a whole -- they cluster in certain industries. Retail and financials are big industry segments for junk.

Also keep in mind that the market for these things is not as liquid as the stock market. If your investment choice is really a sector investment, you might be better served by investing in sector funds with stocks that trade every day versus bonds whose market price may be difficult to determine.