Junk Bonds: Should You or Shouldn’t You?
There are two types of bonds: Investment and Junk. Both are known as ‘debt investment’, which simply means that the investor, that’s you when you buy the bond, is loaning money to the issuer-the group that is selling the bond. For example, if you have any government savings bonds, you loaned the government money when you bought it.
All bonds come with three things: principal amount, maturity date, and coupon.
The principal amount is the amount you paid for the bond, or the amount you loaned the group. The maturity date is the date the principal is due to be repaid to you. Coupon is another word for interest rate. Interest is usually paid every six months until the maturity date, government bonds excluded
Bonds are rated by rating agencies, Moody’s or Standard and Poor’s, for example.
Rating agencies give the bonds a grade based in part on the issuing groups credit rating-a better credit rating would get a better grade. Grades range from AAA being the best to c or D as the worst. (Companies grading formats will vary slightly.)
Bonds that are rated highest, with grades ranging from AAA to BB become Investment Bonds. Bonds that are rated lower, typically anything lower than BB, become known as Junk Bonds. Junk bonds can also be called “high-yield” or “speculative”.
Junk bonds can further be broken down into two categories. Bonds, whose rating is increasing, moving up through the ranks because the issuing groups’ credit rating is improving, are known as Rising Stars. On the other hand, bonds whose ratings are falling because the issuing groups’ credit rating has fallen are called Fallen Angels.
The main reason investors are drawn to junk bonds is the interest rate. Junk bonds have higher interest rates than investment bonds. Interest rates on junk bonds can be between 3 and 7 percentage points higher. That means the investor could potentially make a fairly nice profit.
The drawback is the risk involved. The reason they got rated as junk is because of the groups’ credit rating. The lower the rating, the higher the risk of default. Default is when the issuing group, the one that owes you money, is not able or willing to pay you back when the time comes for them to do so. In that case, you lose your money.
For the average individual investor, it is generally best to avoid junk bonds unless you have excellent analytical skills and have an extensive knowledge of specialized credit. Most of the junk bond market is institutional investors-life insurance companies or pension funds are a couple of examples. If you want to give it a try the safest way is to ask your broker to invest a certain amount of your money in a bond fund, which is a group that invests mainly in bonds and other types of debt investment.
If you are a person with a little money you are willing to risk, be sure to research the groups you are considering investing with thoroughly. Discuss it with your broker. Don’t make any rash decisions. And above all, make sure you can really afford to lose that money.