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High-Yield Bonds: Safer Than Stocks Right Now, but Not Better

It's true that stocks have more risk, but that's only half of the story.


InvestorPlace recently ran a story by Richard Band titled “Why Junk Is a Better Bet Now than Stocks,” which made the case that the rising odds of a stock market correction make high-yield bonds a superior option to stocks right now.

With all due respect to Mr. Band, who certainly has a long and successful track record, his argument doesn’t take the total picture into account. An investor who has fresh cash to put to work right now, and who is evaluating whether to allocate the money to high yield or equities, needs to take a broader perspective than simply looking at the relative risks of the two asset classes.

It’s true that bonds have lower downside risk than equities. Since 1980, high-yield bonds have had four down years vs. six for the S&P 500 Index. The down years for high yield have averaged a return of about -10.2%, but that’s skewed by the massive 27% loss in 2008. In their down years, stocks have averaged a loss of 14.7% — a number that includes a 22.1% decline in 2002 and 37% downturn of 2008. From this, there’s little doubt that Band’s argument holds water: High yield declines less frequently, and it falls less when it does — no surprise there.

Instead, the issue is one of upside. In the event that Band and other bears are wrong and risk assets continue to rally, high-yield bonds have much less room to run than stocks. Absolute yields already are near historic lows, and the average price of the average high-yield bond is close to a record high — which raises the risk that bonds will start getting called away.

An investor in high yield therefore has an asymmetric risk-reward profile at this point — high downside risk, but little chance of meaningful upside. What’s more, absolute yields are now at a level where the income advantage provides much less of a return cushion than it did in the past. The iShares High Yield Corporate Bond Fund (NYSE:HYG) currently yields 5.06%, while SPDR Barclays High Yield Bond ETF (NYSE:JNK) is yielding 5.21%.

In contrast, stocks might carry greater downside risk, but they also offer larger return potential. With valuations near the historical average, the possibility at least exists that we could see an extended bull run following a breakout of the S&P 500 to new highs. Nobody knows if that will happen, of course, but it’s at least a possibility. And based on history, it’s one that doesn’t defy the odds: The S&P has delivered gains of 15% or more in 18 of the past 33 years.

On the other hand, it’s a virtual certainty that high-yield bonds have no shot at delivering total returns of this magnitude from their current levels.

This is borne out by history. While the conventional wisdom is that high yield is so volatile that investors are rarely able to enjoy relatively quiet years in which they simply “clip coupon,” the numbers don’t necessarily support that. In the 33 calendar years from 1980-2012, high-yield bonds produced returns between 0% to +5% on eight different occasions, including five years in a row (1998-2002) where total returns were stuck in a range between -6% and +5%. This indicates that even if the high yield market doesn’t blow up, there is a historical precedent for its being “dead money” for an extended period of time.

The bottom line: Band is correct that high yield has less downside risk than stocks, but it’s clear that stocks have the superior risk-return profile of the two asset classes.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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