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At a certain point, good old stocks and bonds might start to seem a little bit boring. There has to be more out there, especially when you start to build up substantial wealth. These other types of investments are often referred to as alternatives. They sound much more exciting and exclusive than stocks and bonds, and are typically sold as having higher potential returns or diversification benefits that plain old stocks and bonds can’t offer. As Warren Buffett explained in his 2016 letter to Berkshire Hathaway shareholders:

“In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”

Alternative investments are a broad category, so I have split this topic up into multiple parts. In Part One, I will tell you why high yield bonds don’t quite yield enough to justify their risks.

In our low-interest rate world, investors tend to seek out the opportunity to earn higher income yields from their investments. Two of the most common ways to do this are through high-yield bonds and preferred shares.

It is true that, in isolation, high yield bonds have had high average returns in the past. However, including high yield bonds in portfolios has been less exciting. In a 2015 blog post, Larry Swedroe compared four portfolios, one with all of its fixed income invested only in safe 5-year treasury bonds, the other three with each an increasing allocation to high yield corporate bonds. He found that while the portfolios with high yield bonds did outperform by a narrow margin, between 0.2 and 0.5 percent per year over the long-term, they did so with significantly higher volatility than the portfolio containing only treasury bonds. On a risk adjusted basis, the high yield bonds did not add value to the portfolio.

In Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes “Investing in high-yield bonds offers the appeal of higher yields and the potential for higher returns. Unfortunately, the historical evidence is that investors have not been able to realize greater risk-adjusted returns with this type of security.” In his book Unconventional Success, David Swensen, the chief investment officer of the Yale Endowment, similarly denounces the characteristics of high yield bonds, writing that "Well-informed investors avoid the no-win consequences of high-yield fixed-income investing."

On top of all of this, high yield bonds are tax-inefficient. They pay relatively high coupons, which are fully taxable as income when they are received. As an asset that behaves similar to stocks, high yield bonds are a very tax-inefficient way to get equity-like exposure.

High yield bonds do have some proponents. Rick Ferri, a well-respected evidence-based author and portfolio manager, does include high yield bonds in his portfolios.

I do not recommend high yield bonds in the portfolios that I oversee. If you do choose to include high yield bonds in your portfolio, they should only make up a small portion of your fixed income holdings. Due to the risk of default and relatively low recovery rate, it is also extremely important to diversify broadly with a low-cost high-yield bond ETF. I would never suggest purchasing individual high yield bonds.