Junk bonds—or high-yield bonds—can be quite risky, but may still have a place in a portfolio.
Most people don’t spend a lot of time in junkyards, right? They’re strange places, usually off the beaten path, full of low-quality, often dangerous items that no longer fit into the regular world. But there are rare times when junkyards are the only place you can find an item that fits a specific need. All this could be said as well about the financial asset that shares its namesake—the junk bond.
A junk bond is a high-risk but high-yield corporate bond that’s rated below investment grade by Standard & Poor’s, Moody’s, or other rating agencies. Junk bonds have higher returns because the companies that issue them may not be financially sound, so investors demand a premium for taking on the extra risk of the bond defaulting. Junk bonds are sometimes called high-yield bonds.
For most investors, the idea behind bonds is to loan money in exchange for interest, with the assumption that their principal will be returned at maturity. So naturally they focus on bonds with high ratings that show very low risk of the bond defaulting, and not getting their principal back. The junk bond investor is a bit different; they are so motivated by the high interest rate on their bonds that they accept that the default risk is not just real, but maybe dangerously real.
Credit-rating agencies grade bonds using an alphabetic scale, and although there may be slight variations between agencies, Standard & Poor's uses the following grades in order from best to worst.
Government-issued bonds are generally at or near the top grade. For example, U.S. Treasurys had a AAA rating until 2011, when S&P famously downgraded them one notch to AA+. At the other end of the scale, corporate bonds that have already missed debt payments are considered D grade. Bonds rated above BB+ by S&P or Fitch, or above Ba by Moody's, are consider investment-grade bonds and those at or below are considered junk bonds. For more on bonds and bond ratings, refer to “Coupon Clipping for the Investor Set: Your Guide to the Bond Market.”
Junk bonds are highly speculative, but because they generally come with a higher yield, they might be appropriate for certain types of investors, portfolios and strategies. However, some institutional investors such as banks, insurance companies, and pension funds are prohibited in their by-laws from buying bonds beneath certain grades, so the market for junk bonds is typically not as liquid as for investment-grade bonds.
The first junk bonds were investment-quality bonds whose ratings had slipped, also known as “fallen angels.” However, when investor appetite for these bonds picked up in the early 1980s, companies began issuing speculative bonds that were junk grade from the start.
Junk bonds can be considered by investors who are seeking higher yields and are willing to take on the added risk. The most important thing to remember when investing in junk bonds is that they are extremely risky, and if the company that issues the bonds defaults, you can lose 100% of your investment and you will have no entitlement to past or future interest payments.
Investors who want to buy junk bonds might consider doing so during the expansion phase of the economic business cycle. Junk bonds might have a lower chance of default and a better chance of being upgraded within an improving business macro climate.
For investors who don’t want to take on the direct risk of holding junk bonds, there are a number of ETFs and mutual funds that specialize in investing in a more diversified portfolio of high-yield bonds.
Junk bonds are a highly specialized asset, with high returns and corresponding high risk. And remember, they don’t just have default risk, but also the same interest rate risk as any bond. So, make sure you do your due diligence and understand all the benefits and drawbacks before you add junk bonds to your investment portfolio.
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