I love the stock market.
Over time, maintaining diversified exposure to stocks is proven to grow your wealth.
Since the S&P 500 was formed, the average annualized return for owning the index has been around 10%.
At that rate, you can double your money every 7.2 years.
This likely isn’t news to you. As a Wealthy Retirement reader, you’re likely already aware of the stock market’s power to compound wealth over time.
But the stock market isn’t the only game in town…
There is another asset class that you may be less familiar with that has provided returns similar to the stock market’s over the long haul…
That asset class is bonds – more specifically, high-yield bonds.
These bonds deserve a place in your wealth-creation plan. The long-term returns they generate match up well with what you can earn from stocks.
That means adding high-yield bonds to your portfolio mix increases your diversification without sacrificing returns.
The returns will just take a different form…
Investors in stocks mostly earn capital gains, with a smaller amount of income coming from dividends.
Investors in high-yield bonds, on the other hand, mostly earn income from interest payments, with a smaller portion of their returns coming from capital gains.
That means for income-focused investors, high-yield bonds are especially beneficial.
Remarkably Consistent Performance
High-yield corporate bonds did not really hit their stride until the late 1970s and early 1980s.
Their performance over the years allows us to see how this asset class weathers all kinds of situations – changes in interest rates, recessions, oil shocks and almost every other market condition imaginable.
Several different studies have examined high-yield bonds over time. They all show similar results, and most of them focus on how interest rate fluctuations impact performance.
Most bond classes are highly sensitive to interest rate changes. Bonds typically do well when interest rates decline and do poorly when interest rates rise.
High-yield bonds are the exception.
All studies of high-yield bonds have shown that the asset class performs well in both rising and falling interest rate conditions. The data shows that this is a consistent asset class… and a perfect addition to a diversified portfolio.
Below is a table from a study done by the investment firm Hotchkis & Wiley. This study looked at high-yield bond performance over a 30-year period, from August 31, 1986, through December 31, 2016.
It found that there were 176 months when interest rates were rising and 188 months when interest rates were falling. But the performance of high-yield bonds in both conditions was remarkably similar…
And remarkably good.
This three-decade study found that when interest rates were falling, high-yield bonds generated an annualized return of 8.2%.
When rates were rising, the performance of high-yield bonds actually was better, increasing to an 8.8% annualized return.
As With Stocks, Diversification Is Key
The Hotchkis & Wiley study shows that long-term returns for high-yield bonds are nearly 9% annualized. That’s close to what the stock market has generated.
And as long as you know where to look, high-yield bonds can be considerably less risky.
With that record of excellent long-term returns in all market conditions, high-yield bonds are clearly a great source of diversification for our portfolios.
And just as we should diversify our portfolios across different asset classes (stocks, bonds, real estate, etc.), we should also diversify across the high-yield bond component of our portfolio.
Investors shouldn’t look to build big positions in the high-yield bonds of any one company.
Instead, investors should look to diversify into high-yield bonds that have historically generated stock market-like returns and generous amounts of income.