In December investment grade corporate debt soared over 15% as credit spreads plummeted following a crash in September and October.

If you’re debating an investment in high quality bonds then it’s not too late. The Dow Jones Corporate Bond Index yields 7.04% or 460 basis points or 4.6% more than benchmark ten-year Treasury bonds. Twelve months ago that spread was barely 2%, or 200 basis points. Treasury bonds are expensive while corporate debt is cheap.

When comparing the relative risk-reward scenario of stocks versus bonds, I think high quality debt is the optimal asset allocation choice. Any healing in the markets will start with credit, not common stocks.

Stocks will not lead a recovery in 2009. Though a bear market rally remains highly probable – stocks are up 22% since the November 20 low – risk remains high despite a 40% plunge last year. That’s because corporate earnings have fallen off a cliff since the fourth quarter and consensus estimates for the first half still appear too bullish.

Even in a best case scenario for stocks, volatility will remain prevalent and that means a box of Rolaids for most investors. Why take a chance on stocks this year amid the great economic “unknown” when you can tap into 7%-plus yields on corporate debt with the scope for big capital gains if bond prices rise? The tradeoff makes sense.  

Even the largest financial services companies or banks are now backstopped by the federal government. Spreads on these bonds are even wider than non-financial corporate debt and have the implicit guarantee of Uncle Sam since October. For example, Bank of America’s January 2011 notes provide an effective yield of 6.03% or 514 basis points more than Treasury bonds.    

High-yield bonds, or junk bonds, got smashed to pieces in 2008 suffering their worst year on record – down 25%. Junk debt now yields 13.8%, according to the Merrill Lynch High Yield 100 Index. But as the corporate default rate climbs sharply from 3% now to 10% or more this year it’s hard to imagine junk bonds can muster a significant rally. Historically, junk bonds don’t appreciate when the default rate is climbing.     

The stock market can continue to rally this year, similar to 1932 when it more than doubled in a short period of time following an 86% crash from 1929 to March 1932. Yet even after doubling in 1932 from March to late June the Dow finished the year down 15%. Talk about a wild market!

It makes more sense to me as an investor to buy high quality corporate bonds in 2009. You get paid nicely to wait for a recovery in bond prices while stocks remain hostage to great economic uncertainty and more, including regulatory changes, rising unemployment, geopolitical tensions and, most of all, a deep bear market in residential housing.