A junk bond or high-yield bond is a bond rated at “speculative” grade or at “less than investment grade,” likely BB or lower. Its bond has to be markedly higher than a triple A bond to attract investors, and to make up for the additional risk of possible default. As a measure of comparison, the worst rating on a bond is C and a defaulted bond has a D rating.

Over the past twenty-five years, the yield differential between AAA and junk bonds has been between 3-9%, averaging around 6%. The high-yield papers sometimes come with a lock-up period where an investor cannot cash out for one or two years.

It is not that a junk bond is trash; just that the rating agencies are unable to give the kind of rating that can be safely bought by large institutional investors such as pension funds, which have to observe restrictions on the kinds of investments they can make.

Junk bonds are issued by companies which require a significant amount of financing such as utility companies. This form of debt is not new in US capital markets, and issuers in the early twentieth century include General Motors and US Steel.

Junk bonds have tended to outperform the higher rated bonds after a recession, and have been the preferred instrument for 2009, yielding a 43% return as at the end of November 2009, according to Morningstar. Opportunistic investors moved into junk bonds in late 2008 when, in the face of frozen credit, yields on junk bonds went up to more than 20% on the back of falling prices and to richly compensate investors for taking up the risk.

However, a junk bond can be a useful diversification tool if you are intimately familiar with the company and its operations, and investing a small part of your portfolio in a high-yield bond fund might be a good strategy.

Fixed income investments are a type of investment or investment asset class that is made up of securities that have a fixed price and pay some sort of interest at regular intervals.  Here are some examples of fixed income investments:

• Bonds – There are many different types of bonds but one of the more famous types is US government treasuries.  I-bonds, municipal tax free bonds are other examples.  These are the traditional type of fixed income investments where the investor buys the bond from an issuer, receives regular interest payments and then at the end of the term, receives their original investment back.
• Zero coupon bonds – These are bonds where there are no actual interest payments but instead the investor buys the bond from the issuer at a discount from the bond face value and after a number of years (the term), the investor gets the face value amount from the issuer.  The interest payments in this case are implied rather than paid direct.
• TIPS – Treasury Inflation Protected Securities – These are bonds that are adjusted annually to reflect changes in the rate of inflation as measured by the consumer price index.
• Preferred shares – These are hybrid securities which pay dividends but share some of the characteristics of bonds along with equities.
• Certificate of Deposits – CDs are usually available from banks and brokerages.

Fixed income investments secondary market

Fixed income investments can be purchased from an issuer which might be the United States government in the case of treasuries or from a company.  They can also be bought and sold in the secondary market which will be a transaction between two investors.  Secondary market transactions will value the bond at the current market rate – there are various factors which affect the price of bonds.

Differences between fixed income investments and equities

The main differences are:

• Bonds retain their nominal value.  A bond with a $1000 face value will be worth $1000 at the end of the term.
• Bonds pay interest.  Some stocks pay dividends but a lot don’t.
• A fixed income investment is a loan to a government or a company.  A stock purchase means you are a part owner of a company.
• Governments issue bonds but never issue stock.

Reasons to own fixed income investments – asset allocation

The reason investors own fixed income is for safety and diversification.  While stocks are a great investments for the long term, sometimes they fall in price.  2008 was a very volatile year for equity investors and the investor who owned some bonds along with her stocks probably slept a lot better than the investor who was 100% invested in equities.

Most investors own bonds via mutual funds or a target retirement fund.  Bonds are thought of as a very safe investment compared to stocks because their principal amount doesn’t change.  If you buy a $5,000, 10 year bond paying 6%, then in 10 years you will get your $5,000 back plus interest.    Seems safe enough but what happens if you sell the bond before the term is up?

Bond prices if interest rates rise

What if inflation has taken hold of the economy and interest rates have gone up?  What if after 5 years the new government 5 year bonds are paying 10%?  Can you still get $5,000 for your 6% bond?  Not likely – a new investor with the choice between a new 5 year bond paying 10% and your 5 year (remaining years) bond paying only 6% will undoubtedly choose to buy the higher interest government bond.

The only way that investor is going to consider your 6% bond is if you lower (or discount) the value of the bond so that the combination of capital gain and interest payments will equal the 10% interest payments which are currently available on new bonds.

Please note that all calculations are approximations.  I’m also ignoring inflation which is also an important factor.

Since the existing interest payments on your bond are 6% then the investor will need to discount the value of your bond to give him 4% increase per year.  If he buys your bond for $4110 and then redeems it after 5 years for the principal amount of $5,000 then this will give him the remaining 4% return.  This would only be true if interest rates remain at 10% for new bonds.  In actual fact most people would assume they probably wouldn’t.

The opposite effect is observed if interest rates decrease since bond values will increase.

Does this effect hold true for all bonds?

The rule of thumb is that when valuing a bond – the more time until maturity – the more the value of the bond will be affected (good or bad) by current market interest rates.  A bond that is going to mature in a year or two will not change much in value if interest rates change.  A bond that has a long time before maturity will have large value changes if interest rates change.

Interest payments occur when you lend someone money and they pay back more than they borrowed.  For example, when you deposit money into a high interest savings account, then the bank will give you interest payments for lending them the money.  (Note: interest payments also occur when you borrow money, but then you pay interest to the lender.)

An example interest payment

Bob buys a 10 year $1,000 bond from company XQY which pays a 5% interest payment per year payable at the end of each year.  Bob will receive a $50 interest payment each year for 10 years. At this point he will also get back his original $1,000 investment.   If Bob is holding this investment in a taxable account then he will have to declare the interest payment of $50 on his income tax form each year.  If the investment account is non-taxable account like a 401k plan, then he doesn’t have to worry about the taxes.

If your portfolio contains some sort of fixed income, then you will receive interest payments from that investment.   Examples of such investments could be bonds, certificates of deposits, mutual funds or exchange traded funds.  It is not always obvious when you are getting interest payments – if you buy a mutual fund that is balanced fund (contains bonds and stocks) then some of the dividends received from the fund will be from interest payments.  It is also possible for a stock mutual fund to pay some interest because it can earn interest on any cash it holds.

Other bank account alternatives

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Bonds, also known as fixed income, are an investment you can purchase where you essentially lend money to whoever issued the bond in exchange for future income in the form of interest payments.  At the end of the life of the bond, you get your original investment back.  The interest payments and principal (amount of your investment) are guaranteed by the company or government that issued the bonds.

Who issues bonds?

There are different types of bonds and different types of entities that issue them.  Government bonds are issued by different levels of government which can range from a small town to the U.S. government.  Corporate bonds are issued by companies and although the companies can be small or large, most corporate bonds are issued by the larger companies.

How do you make money with a bond?

Most bonds pay a set amount of money every so often to the holder of the bond (that’s you).  You are lending money out (via the bond) and the borrower (issuing company or government) pays you interest.  This is the same sort of thing that happens in a savings account when your bank pays you interest on your deposits.

Why would I want to buy a bond?

Bonds are considered a less risky investment compared to stocks because the interest payments and principal are guaranteed by the issuer.  Typically, “safer” bonds that are issued by the US government pay a lower interest rate, whereas “riskier” bonds issued by companies will pay a higher interest rate to compensate for the extra risk.

The risk with bonds is that if the company or government that issues the bond goes bankrupt or runs into financial problems, then the bond holder may not get their money back.

Fixed income investments are defined as securities that have a regular fixed return associated with them as well as having a guaranteed principal.  This investment asset class is often considered less risky than buying stocks which isn’t always true since some fixed income investments are very risky.

A fixed income security is only as good as the organization that issues it.  If you buy a bond from a company and they don’t have any money to pay the interest, then you are out of luck.  Worst case scenario is the company goes bankrupt, in which case you probably won’t get your original investment back.  On the other hand, a bond issued by the United States government is about as safe as you can buy.

Here are some examples of fixed income investments

Regular bonds are investments where you lend money to a government or company in return for periodic interest payments.  At the end of the bond term you will receive your original investment back.  For example you might buy a bond for $5,000 that pays 4% per year for 10 years.

Preferred shares – these are special shares issued by companies that have a fixed dividend attached to it.  These are normally defined as fixed income but share some characteristics with regular stocks.

Zero coupon bonds still involve lending money to a government or company but instead of receiving regular interest payments you get the “interest” at the end of the term.  For example you might buy a zero coupon bond for $500 and after 7 years, the borrower will pay you $900.

TIPS – these are inflation-protected bonds issued by the US government.  These tend to pay a low return but because the inflation index is built in, they can be a good hedge or guard against high inflation.