Thanks. Makes sense now.

Junk Bonds: all interest is taxed. Equities: dividends not taxed and capital gains included at 25% or 50% depending on whether you’re an individual or a corporate. So yes, equities are more tax efficient than debt, therefore debt is better (from a tax perspective) for tax-exempt investors.

I understand the tax logic. But in real life, do tax regulations differ for equities and bonds? If so, then all makes sense. If not, I still don’t see why junk bonds would be a better investment than risky equities, (risk , return, tax being equal).

Ok, let’s take 2 investments – equal payoff and equal risk (however you want to measure it). The market should price these to be the same so that they should, on average, generate the same return for investors.

Now, let’s say one of these is tax-exempt (an exaggerated case of equities’ tax position) and the other is fully taxable (like junk bonds). Now, all the tax-paying investors in the market will strongly prefer the tax-exempt returns of the “equities”. The will buy more equities and sell junk bonds, until the after-tax yield on each is the same.

A tax-exempt investor can now buy the junk bond much more cheaply than the equity and earn a higher return on it since they don’t have to worry about paying tax.

Because market prices are set by the market as a whole, pensions funds with an advantage in investing in highly taxed investments should invest more heavily in just those investments.

I was actually primarily referring to Defined Benefit schemes where the investment choice is made by the trustees. If you have the choice yourself, then you should try to find a junk bond or mezzanine debt heavy portfolio to opt into.

Also, I assume you’re talking about pension funds that don’t give investment options to their members? In my fund at least, I can easily switch between stable, moderate and aggressive.