Investment scams such as those perpetrated by Ivan Boesky and Michael Milken, known as the “junk bond kings” of the 1980s, can bring back unpleasant memories for people who hear the term “junk bond.” However, if you currently own a bond fund, it is possible that some of this so-called junk has already made its way into your portfolio. And that isn’t necessarily a negative development.
What you need to know about junk bonds is outlined below.
A junk bond, like any other bond, is a debt-based investment. Companies or governments can borrow money by issuing promissory notes that state how much money they are borrowing (the principal), when they expect to return your money (the maturity date), and the interest rate (coupon) they will pay you on the money they have loaned you. The interest rate represents the profit that the investor will make as a result of lending the money to the borrower.
The Most Important Takeaways
- In order to attract investors, junk bonds must offer higher interest rates than investment-grade bonds because their credit ratings are lower than those of investment-grade bonds.
- S&P and Moody’s both rate junk bonds as BB[+] or lower, with Standard & Poor’s rating as low as BB[+] and Moody’s at Ba or lower.
- According to the rating, there is a high likelihood that the bond issuer will default on its debt.
- A high-yield bond fund is one option for investors who are interested in junk bonds but are hesitant to pick them out one by one themselves.
In order to be issued, every bond must be rated by either Standard & Poor’s or Moody’s, which are the major rating agencies tasked with determining the issuer’s financial ability to repay the debt it is taking on. The ratings range from AAA (the highest) to D (the lowest) (the company is in default).
The labeling conventions used by the two agencies are slightly different. For example, AAA from Standard & Poor’s is equivalent to Aaa from Moody’s.
All bonds, in general, can be classified into one of two categories:
- Investment-grade bonds are issued by lenders who are considered to be low- to medium-risk. Investment-grade debt can be assigned a bond rating ranging from AAA to BBB. Because their issuers are not required to pay more, the interest rates on these highly rated bonds are relatively low. Investors looking for a safe haven for their money will be interested in purchasing them.
- Junk bonds carry a higher level of risk. Standard & Poor’s will assign them a rating of BB or lower, and Moody’s will assign them a rating of Ba or lower. These lower-rated bonds offer a higher yield to investors than their higher-rated counterparts. Their purchasers are receiving a greater reward for taking a greater risk with their purchase.
Bonds with a low credit rating and bonds with a high credit rating
Consider a bond rating to be the report card on a company’s creditworthiness and financial strength. Bonds issued by blue-chip companies with strong financials and a consistent stream of income will be given a high rating. Companies and government entities with a history of financial difficulties will receive a lower credit rating.
The bond-rating scales used by the two major rating agencies are depicted in the chart below.
In the past, the average yield on junk bonds has been 4 percent to 6 percent higher than the yield on comparable U.S. Treasury bonds, on average. American bonds are generally regarded as the gold standard for investment-grade bonds due to the fact that the country has never defaulted on a debt obligation.
Bond investors divide junk bonds into two broad categories: illiquid and toxic.
- Known as fallen angels, these bonds were once rated investment grade but have since been downgraded to junk bond status as a result of growing concerns about the financial health of the companies that issued the bonds.
- Rising stars, on the other hand, are the polar opposite. The companies that issue these bonds are showing signs of improvement in their financial standing. Their bonds are still considered junk, but they have been upgraded to a higher level of junk, and if everything goes according to plan, they could be on their way to becoming investment-grade.
Who Invests in Junk Bonds?
The obvious caveat is that junk bonds are a high-risk investment that should be avoided at all costs. There is a possibility that the issuer will declare bankruptcy and that you will never see your money again.
Even though there is a market for junk bonds, it is overwhelmingly dominated by institutional investors who have the resources to hire analysts who are well-versed in specialized credit issues.
This does not imply that investing in junk bonds is only appropriate for the wealthy.
The High-Yield Bond Fund
Individual investors who are interested in junk bonds may find it beneficial to put their money into a high-yield bond mutual fund.
You’re dabbling in a higher-risk investment, but you’re putting your trust in the expertise of professional money managers to make the right decisions for your money.
High-yield bond funds also help to reduce the overall risk to the investor by diversifying their portfolios across a variety of asset classes and investment strategies. An investment in bonds rated from Baa3 to C, for example, is maintained by the Vanguard High-Yield Corporate Fund Investor Shares (VWEHX). The fund invests 4.5 percent of its assets in U.S. bonds and 3 percent in cash, with the remaining portion allocated to other investments. The Fidelity Capital and Income Fund (FAGIX) invests nearly 20 percent of its assets in stocks, according to Morningstar.
One thing to keep in mind: before investing in a junk bond fund, you should determine how long you are willing to commit your money. Many do not allow investors to cash out for at least one or two years after they make their initial investment.
In addition, there comes a point at which the rewards of junk bonds no longer outweigh the risks associated with them. In order to determine this, you should look at the yield spread between junk bonds and United States Treasuries. Historically, the yield on junk bonds has been 4 percent to 6 percent higher than the yield on US Treasury bonds. If you see the yield spread shrinking to less than 4 percent, it’s probably not worth taking on the additional risk at this point. to make an investment in junk bonds
Another thing to keep an eye out for is the default rate on subprime bonds. This information can be found on the Moody’s website.
One final word of caution: junk bonds, like stocks, are subject to boom and bust cycles. During the early 1990s, many bond funds generated annual returns in excess of 30 percent on average. In the event of a large number of defaults, these funds may experience spectacularly negative returns.