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.