Bullish On Stocks? There May Be A Better Alternative

by: Plan B Economics

While many parts of the global economy are clawing their way out of a very deep hole, it is undeniable that segments of the US economy are definitely improving. Compound that with what appears to be a soft landing in China and a huge kick of the can that is the European debt crisis and we could be in for a few years of growth.

By no means have we solved all our problems - many parts of the developed world still face what could be insurmountable budget problems. But frankly the markets knew of these problems twenty years ago and we still experienced a few fantastic bull runs.

If you are bullish on the markets your first inclination might be to look to stocks (investable broad stock market ETFs include (NYSEARCA:SPY), (NYSEARCA:DIA), (NASDAQ:QQQ)) as the best way to profit. However, research suggests that other choices exist. Namely, high yield bonds may provide a better alternative to the stock portion of a balanced portfolio.

High yield bonds are typically viewed as a way to diversify the fixed income portion of a portfolio. However, because of the risk-return characteristics illustrated below, I prefer to view high yield bonds as a hybrid asset class, possibly even substituting for equity allocations.

Using available data (i.e. high yield data available to 1997), below I have compared risk-return characteristics for the S&P 500 Total Returns Index and BofA Merrill Lynch US High Yield Master II Index (investable high yield bond ETFs include (NYSEARCA:HYG), (NYSEARCA:JNK), (NYSE:PHB)).

The first graph below compares the cumulative growth of $100 invested in each index since the inception of the High Yield index. As you can see, High Yield bonds far outpaced stocks across the entire market cycle.

How did high yield bonds perform so well? Some might say that high yield bonds win by not losing. As you can see, the high yield index virtually avoided the Tech Wreck (early 2000s) and the Financial Crash (2008), while equities plummeted on both occasions.

So what if the comparison excluded the Tech Wreck, thus stripping out the relative downside protection provided by high yield bonds during the first bear market? The illustration below shows that high yield bonds still outperformed. Furthermore, the second illustration below strips out both the Tech Wreck and the Financial Crash. In this illustration high yield bonds more-or-less performed in line with equities.

Let's zone in on what "winning by not losing" really looks like. The chart below shows the best and worst calendar year performance for the S&P 500 and BofA Merrill Lynch US High Yield Master II Index. While the best calendar year performance is basically equivalent for both asset classes, the worst calendar year performance is miles apart. Based on this data, it appears that high yield bonds have provided upside similar to stocks with far less downside.

While loss of capital is the primary measure of risk, volatility (i.e. standard deviation of returns) is also a commonly published manifestation of risk. Based on the available data, high yield bonds exhibit about half the volatility of stocks.

Below I calculated returns per unit of volatility to illustrate the risk-adjusted returns for each asset class. This measure truly summarizes the story for high yield bonds - on a risk-adjusted basis, high yield bonds have historically outperformed.

So my question is this...if you are considering investing in stocks for any reason (i.e. bullish, long-term strategic allocation) why not consider instead using high yield bonds?

Think about it this way. If you like company XYZ because you feel it is well-managed and has good prospects, would you rather buy its stock which pays no dividend and is lowest-ranked on the capital structure or buy its bonds which yield 7-8% and take priority in the event of distress?

Of course, the argument for buying the stock is the theoretical unlimited upside and the possibility of rising dividends in the future. But for many companies this is more of a fantasy than a forecast, and on an aggregate level the data appears to validate this.

Of course, the data could be sliced and diced a million different ways (e.g. rolling 12mth returns, maximum drawdown analysis, etc.), so I caution against considering these conclusions gospel. The goal of this article isn't to provide conclusive evidence one way or another. The goal is to show investors that there are alternatives to stocks for the "growth" portion of a portfolio and that high yield bonds need not be isolated to the fixed income portion of a portfolio.

The world of asset allocation isn't black and white (stocks and Treasuries (NYSEARCA:TLT)). There are many shades of grey, and I believe high yield bonds are a hybrid asset class that may substitute for equities under the right conditions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Data Sources: St Louis Federal Reserve, Robert Shiller. This is not advice. This site features the opinions of the various authors and sources. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.