What Are Junk Bonds?

by ABC

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.

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