Back in the 1980’s, a number of financial scandals occurred, involving junk bonds. The criminal prosecution of trader Michael Milken, the “Junk Bond King”, propelled junk bonds into the headlines, and was soon followed by a collapse in their values.
Although junk bonds have not since had the same level of media attention, they still exist. Even though the “junk” label makes them sound worthless, junk bonds have a place in some investment strategies. If you have invested in a bond fund, there’s a good chance that the fund includes some junk bonds.
A junk bond, or a speculative grade bond, is a bond that carries a high risk of default. Otherwise, a junk bond is not actually much different from any other bond. You purchase the bond from its issuer, the principal, and the issuer promises to pay you back by the bond’s maturity date, with interest (coupon) on the money it borrows through the bond issue.
The key between a junk bond and other bonds is risk. The issuer of a junk bond has lower credit quality, and thus a junk bond — or as the issuers would prefer it be called, the high-yield bond — offers investors a higher rate of interest than a safer, investment-grade bond.
Junk bonds are normally rated BB or, while investment-grade bonds are normally A-rated or rated no lower than BBB. Investment grade bonds offer a lower interest rate, and thus lower returns, but are considered to be a much safer investment than a high-yield bond. Consider the implication of that rating system: A junk bond is not considered to be investment grade. The lower a bond’s rating, the more likely it is that the issue of the bond will default and that bond investors will lose their money.
The interest rate on a junk bond is often four to six percent higher than the interest rate on an investment grade bond.
Junk bonds may be issued by any company that has poor credit. The issuer may be a newer company, that hopes to become more successful with funds raised through the bond issue, or it may be an established company with a diminishing credit rating.
If a company makes a bond issue while it has good credit, but it experiences difficulties that cause its credit to diminish, the company’s bond issue may be downgraded to junk. That type of bond issue is known as a fallen angel. Although investment in a fallen angel will often be at lower risk than other junk bond investments, the risk remains high — too high for most individual investors.
A junk bond issued by a company that sees a subsequent improvement in its credit score may be described as a risking star. While it is possible that some rising stars will eventually become investment grade, the risk of putting your money into any non-investment grade bond remains very high.
The potential high yield of the junk bond comes with high risk. For most individuals, the risk of investing in a junk bond will significantly exceed the potential benefit.
Any person investing in junk bonds must consider:
- Risk of Loss: Although any investment carries the risk that you’ll lose part or all of your investment, the risk associated with junk bonds is high.
- Your Knowledge of the Industry: Unless you have the information and experience necessary to evaluate the issuer of a junk bond, its market and potential, your risk in making an investment is very high.
Investment in junk bonds is thus best left to people who have enough money to risk a significant loss, and the time and knowledge to spend evaluating investment opportunities in order to reduce investment risk. A sophisticated investor who is willing to accept a significant risk of loss, a third or more of the investment, may want to consider investing in an assortment of junk bonds, but they have little place in the portfolio of a conservative investor.
Junk Bonds are Best Left to Professional Investors
An investor with less time, knowledge and experience may be willing to absorb some risk through investment in a junk bond fund, but it is important to examine the rules of a fund before you invest your money. Many junk bond funds require a minimum period of investment, such as two years, before the investor may withdraw any funds. Also, history indicates that past performance of a bond fund is a poor measure of future success, with the returns (and losses) on junk bond funds tending to follow a boom and bust cycle.
Before making any investment in junk bonds, it is important to examine the rates of return on the bonds. If the rates are not much better than investment grade bonds, or the difference is likely to be significantly reduced by rising interest rates, then it is a poor time to invest in junk bonds.
If you receive a cold call from a company that tries to convince you to invest in junk bonds, you should decline the opportunity. That sort of boiler room operation is unlikely to be pushing anything but the highest risk bonds, with the goal of profiting from commissions on their sales. They will suggest a high probability of investment success with high returns, when the truth is that you’re far more likely to experience a total loss on your investment. Sometimes a bond won’t lose all of its value in a default, but the chance of a modest residual value does not overcome the risk of loss.
Consider the Risk
To make a long story short: If you are wealthy, understand the risks, and have the knowledge or resources to make informed investment in junk bonds, then they may be an appropriate addition to your much larger portfolio. But even then, the purchase of junk bonds is best thought of as highly speculative, and not as a sound investment decision.
If you are an average investor, prefer conservative investments, or can’t afford to lose every penny of your investment, you should stay away from junk bonds. An individual investor who is willing to accept the risk and restrictions on withdrawal of funds may consider investing in junk bonds through a professionally managed bond fund.
|Very Good Quality||AA|
|Lower Medium Quality||BB|