In the most basic sense, junk bonds are no different from regular bonds. The behavior is the same, but the key difference is the risk that’s involved with investing in junk bonds. If you accept the risk, the bond issuer rewards you with a higher interest rate, however, you could lose big if the company ultimately defaults on the bond.
Briefer on How Bonds Work
When corporations, governments, or municipalities need to raise money, they issue bonds which are basically IOUs. You, the bond purchaser, loan money to the entity that needs the loan, i.e. the bond issuer. In exchange, the bond issuer pays interest (fixed or variable) on the loan. The interest rate is known as the coupon and the date by which the loan has to be repaid is called the maturity date. Bond payments are made twice a year and at maturity, the full face value of the bond is repaid.
Bonds are an attractive investment since they offer a fixed amount of return for a certain period of time. Retirees typically find bonds more attractive since they return a fixed amount of money without the risk and volatility of stock markets. Short-term bonds are also a good option when you’ll need the money within a certain amount of time, but can’t afford the risk that it could get lost in the stock market.
With bonds, you don’t have any ownership in the company, therefore you have no voting rights, and you don’t get to share in company profits. These are benefits of owning stock. But, you do get a higher claim in the entity’s assets if they file bankruptcy. Or, if the company or government is short on cash, bondholders get payments before stockholders get their dividends.
What Makes a Bond Junk?
All companies are given a credit rating from agencies like Moody’s and Standard and Poor’s. Possible ratings range from AAA to C and even D. Bonds with a rating of BBB are medium risk, while bonds with B and C rating are highest risk. Bonds with a rating between BBB and AAA are considered investment grade bonds and those below BB are non-investment grade, or junk bonds.
Because of their medium to low rating, companies that issue junk bonds may not be able to get low cost financing from other sources. But, the bonds they issue aren’t exactly low cost either. Junk bonds pay higher interest rates than bonds from safer entities because of the risk associated with the company. These are often referred to as high yield bonds. No one would purchase a low rate bond from a company that has a higher risk of defaulting on their bonds. While the higher interest rate may sound attractive, there’s a high risk that a company issuing a junk bond will default on the bond and you might never get your money back.
Junk Bond Classifications
Junk bonds can be classified as fallen angels and rising stars. Fallen angels are bonds from companies that once had a high rating, but have recently had their rating reduced. Rising stars have improved their low credit rating, but have yet to earn a low risk credit rating. Both of these classifications may have their investment merits.
Investing in Junk Bonds
If you’re thinking about investing in junk bonds, look at the bonds default rate and the spread between junk bonds and U.S. Treasuries. If there’s only a short distance between Treasury bonds and junk debt bonds, then it’s not a good investment.
You always have the option in investing in a fund that’s invested in junk bonds. You can save yourself the trouble of scouting out junk bonds yourself. A professionally managed fund can provide the bond experience you may be lacking, and provide the safety of diversification. But, you should still look at the bond holdings of any bond ETF you’re considering. Some mutual funds also invest in junk bonds, but mutual funds tend to have higher costs than ETFs.