@Returns Reaper – I have not yet read Swensen’s book, but it comes highly recommended by many. Your points mentioned are excellent, and may help explain why you need to spend proportionately more units of risk trying to earn higher units of returns from bonds versus equities.

Another source of information along the same lines is one of my favourite books, David Swenson’s ‘Unconventional Success’. He suggests any desire to earn anything above government bond rates should be achieved by increasing exposure to equities, not investing in riskier bonds. Some reasons for this include:
- corporate management teams interests are more aligned with stockholders than bond holders. The management team typically holds stock or has stock options. So if they have to choose whether to negatively impact bond holders or stock holders, they’re likely to choose bond holder.
- the return on most corporate bonds have only one way to go.. down. They typically have clauses that allow them to recall the bonds (and typically reissue at a lower rate) if interest rates go down or their credit rating goes up. If their credit rating goes down or interest rates go up, you’re holding a suboptimal investment.

I think there were some more points as well, but I’d have to re-read the section on corporate bonds to remember them. But your conclusions are essentially the same as his: the extra risk of high yield corporate bonds doesn’t compensate with as much expected return as the same amount of risk taken in equities.

Now, preferred shares are a bit of a different animal. I don’t think there are too many big fans of perpetuals out there, so the same restraints on what slice of the preferred share market you add to your portfolio is probably not a bad idea, i.e. keep them higher credit quality and shorter maturity (or at least shorter time-to-reset). Other than that, I’m fine with adding prefs to the fixed income mix in moderation.

Also, I subscribe to a core-satellite approach where 80% goes into a disciplined portfolio, and 20% is dedicated to individual picks and active trading. Allows me to have structure while appeasing my human nature! :)

Very timely post, as I have been mulling the very same topic recently.

I would be interested in your views on how dividend stocks and preferred shares factor into this picture (especially given their after-tax advantages).

Regards
q