With income trusts facing new rules in 2011, investors are looking for other income-producing securities to fill the gap. Many are looking for a one-two punch of dividend-paying stocks and high-yield bonds.

The growing appeal of high-yield bonds shouldn’t be surprising in an era when five-year Government of Canada bonds are paying just 2.5%. Investors are hungry for yield, and they appear to be willing to take more risk to get it. But are these bonds a good addition to a portfolio, or do their big payouts come with too much volatility?

What are high-yield bonds?

Before considering that question, let’s clarify what high-yield bonds are. Standard & Poor’s assigns all bond issuers a rating between AAA and D according to how likely they are to meet their debt obligations. The bonds of companies rated AAA (“Extremely strong capacity to meet financial commitments”) through BBB (“Adequate capacity”) are called “investment grade.” Companies ranked BB or lower are more likely to have trouble meeting their commitments. Their bonds are deemed “speculative grade” by S&P, and are often called “junk bonds” by investors. The financial industry prefers the more positive-sounding “high-yield bonds.”

As the name suggests, high-yield bonds reward investors for the added risk with higher interest payments. The current yield to maturity on AAA-rated corporate bonds in the DEX All Corporate Bond Index is just 2.2%, rising to 4.1% for BBB-rated issues. B-rated bonds yield a hefty 8.7%, and if you’re willing to reach as low as CCC, you may earn 10% — as long as the issuer doesn’t default, of course.

It’s clear, then, that high-yield bonds present an opportunity to earn substantial returns. So now that there are plenty of ETFs tracking this asset class, should high-yield bonds be part of a well diversified index portfolio?

There’s no simple answer. I went to four of my favourite financial authors for some guidance, and two came down on each side. Today we’ll look at the arguments against high-yield bonds, and on Wednesday we’ll consider the reasons why they may indeed have a place in a Couch Potato portfolio.

The argument against: “Bonds should be safe.”

The strongest argument against high-yield bonds is that fixed-income investments are supposed to provide ballast in a portfolio. If you want to take more risk in pursuit of higher returns, the thinking goes, then take it on the equity side.

Government bonds may have low yields these days, but they also have a very low correlation with equities: they tend to go up when stocks go down, and vice-versa. This is especially true during times of crisis, when investors are running for safety. When just about everything else went into freefall between September 2008 and March 2009, for example, government bonds rose in value by more than 5%.

High-yield bonds, on the other hand, offer none of this safety. Indeed, when equities crash, high-yield bonds tend to plummet along with them. According to Rob Carrick in the Globe and Mail, “in 2008, amid the worst conditions imaginable, high-yield bond funds lost 15.3 percent on average and some big players lost between 20 and 40 percent.”

Larry Swedroe, who writes the excellent Wise Investing blog on CBS MoneyWatch, takes a long-term look at this issue in a recent post called High-Yield Bonds’ Effect on Portfolios. Swedroe found that over the 20-year period ending in 2009, high-yield bonds outperformed five-year Treasuries by about 0.5% annually. Then he compared the performance of two portfolios with 40% bonds and 60% stocks. Portfolio A included only high-yield bonds on the fixed-income side, while Portfolio B included only five-year Treasuries. Both were rebalanced annually.

The surprising result: over two decades, Portfolio A had slightly lower returns and dramatically higher volatility than the Portfolio B. The Treasury bonds had a negative correlation with stocks over that period: when one asset class zigged the other tended to zag, smoothing out the investor’s ride. With regular rebalancing, the safer portfolio also yielded higher returns.

David Swensen, Chief Investment Officer at Yale University and the author of Unconventional Success, takes an even stronger position on high-yield bonds. The portfolio he suggests in his book includes only government (nominal and real-return) bonds on the fixed-income side. Swensen argues that the marginally higher returns of investment-grade corporate bonds are not worth the added risk: “Under normal circumstances investors receive scant compensation for the disadvantageous traits of corporate debt,” he writes. Investors in high-yield bonds face an even worse risk-return trade-off.

In Part 2, I’ll look at two other well-known investment experts who argue that high-yield corporate bonds should be part of a diversified portfolio.