Junk Bonds

As investors in bonds, we have a large choice of issues to choose from in the market.  One of those options includes high yield debt, more commonly referred to as junk bonds.  But as we'll see, the greater returns of these bonds are a direct result of their greater risk of default.

In this publication, we're going to cover the topic of junk bonds.  As part of that discussion, we'll talk about the bond rating system, and its relationship to risk and reward.  We'll also see how that system can be used to identify junk bonds.  Next, we'll talk about the various investment options that are available to individuals that wish to participate in this market, as well as the best time to buy junk bonds.  But first, we'll briefly review the history of these investments.

Investing in Junk Bonds

Also referred to as high yield bonds and speculative grade bonds, junk bonds is the label given to bonds that are considered non-investment grade.  Throughout the 1970s and 1980s, there was a sharp rise in investor interest in junk bonds.  The popularity of these issues is often associated with Michael Milken.  While working at Drexel, Milken was both the visionary as well as a strong proponent of these "fallen angels" and "rising stars."

Fundamentally, Milken believed that junk bonds offered investors exceptional value.  He argued that because the market ignored the bonds of these troubled companies, they offered the investor the opportunity to realize above average returns.  Investors as well as large financial institutions agreed with Milken's vision, and the junk bond market flourished.

Junk Bond Ratings

By definition, junk bonds are non-investment grade.  They're considered riskier to own than investment grade bonds because the issuing company is experiencing financial challenges.  They're either large companies that are suffering financial distress (fallen angels) or start-up companies that are expanding faster than desired (rising stars).

Bond rating agencies are responsible for evaluating a company's risk of default.  The bond market relies on the ratings provided by three agencies - Moody's, Standard and Poor's, and Fitch Ratings.  The system used by each company to indicate the quality of a company's bond offering appears in the table below.

Bond Rating Grades

Note to Bond Rating Table:  Moody's uses a modifier of 1, 2, or 3 to show relative standing in a category.  Standard and Poor's and Fitch Ratings use a modifier of plus or minus.

Bond Yields

As indicated in the table above, ratings assigned by these agencies of Ba, BB, and lower quality would be considered non-investment grade bonds.  The market price of these bonds would be heavily discounted, and bond yields would be well above average.

You can use our bond yield calculator to help you determine a bond's yield to maturity, as well as its current yield value.  In fact, only four data elements are needed to calculate bond yields - current bond price, par value, coupon rate, and the years until maturity.

For a deeper understanding of the calculation, as well as the importance of this financial measure, we have an entire publication dedicated to the topic of bond yields.

Evaluating Junk Bonds

Whenever you're buying a bond, you're lending money to someone that has promised to pay back the loan at maturity.  The ability of the issuing company to repay this debt is reflected in their bond rating.

If a bond rating indicates the company may have difficulty in repaying that debt, as is the case with junk bonds, then an investor should carefully consider that possibility before buying the bond.  That's why junk bonds are considered speculative, and lower quality bonds are even labeled as such.

Interestingly, the movements of junk bond prices don't always follow those of higher-grade bonds.  While most bond prices usually move in the opposite direction to interest rates, junk bond prices tend to follow economic conditions - just like stocks.

Because the probability of default on a junk bond increases during a recession, prices of these issues usually decline during rough economic times.  On the other hand, when the economy begins to improve, and the risk of default diminishes, the prices of junk bonds tend to rise.  In fact, the best time to invest in junk bonds often coincides with economic upturns.

Buying Junk Bonds

Investors wishing to buy junk bonds have several options available to them:

• Corporate Issues - it's possible to buy bonds that are issued by a single corporation.  Such issues are frequently purchased through brokers.
• Mutual Funds - it's also possible to reduce your overall exposure to the default risk associated with a single company by purchasing shares of high yield / junk bond mutual funds.
• EFTs / Index Funds - finally, there are offerings of exchange traded funds such as iShares iBoxx $ High Yield Corp Bond (HYG) and SPDR Barclays Capital High Yield (JNK).

When evaluating a junk bond fund, it's important to understand the fund's objective.  For example, is the fund investing in near-investment quality bonds, or are they seeking higher yields from more speculative offerings?  It's also important to understand how the fund performed during tough economic times relative to its peer group.  This information can help the investor to understand how that fund might perform in the future.

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