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Understanding the Basics of Junk Bonds

written by: Shobha Sriram•edited by: Jason C. Chavis•updated: 7/17/2011

Most investors find junk bonds risky as they are below investment grade. However, these bonds can offer high rates of return and are highly profitable to bond funds. Investors need to have a complete understanding of junk bonds to determine how to invest in them.

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    Explaining Junk Bonds vs. Other Bonds

    So what is a junk bond? A junk bond is like a regular bond – in that it promises to pay coupons on the borrowed money and reissue your principal on the maturity date. However, these bonds differ heavily on the basis of the underlying credit quality of the issuers.

    The credit-quality of the borrower forms the basis of bond rating. It signifies the risk of default by the borrower. When the underlying default risk of the issuer is between low and medium, the bond meets the requirements of the investment grade category. The 'AAA' bond rating reflects low risk while the 'BBB' rating reflects medium risk. The letters, ‘AAA’, or ‘BBB” signify grades that indicate the credit worthiness of a company. Blue-chip companies normally considered safe investments get high ratings, whereas risky companies get low ratings. Though these bonds may not offer huge returns, they are attractive due to the low risk of default on interest payments.

    Junk bonds, on the other hand, offer high yields in order to compensate bondholders for the default risk. Their rating grades at 'BB', 'B', 'CCC', 'CC', and 'C'. Such low rating makes it extremely difficult for the issuers to obtain capital at low costs.

    The indices where junk bonds trade include Citigroup US High-Yield Market Trade Index, CFSB High Yield II Index (CSHY), Bear Stearns High Yield Index (BSIX), the Merrill Lynch High Yield Master II (H0A0) and the Barclays High Yield Index. However, if you want to trade only in 'BB' or 'B' rated junk bonds, you can trade on specialized indices, such as the Merrill Lynch Global High Yield BB-B Rated Index.

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    How Does Global Flow Impact the Price?

    Issuers in Europe, Asia and South Africa have recently shifted to issue junk bonds to raise capital for re-financingglobal  and acquisitions. In 2010, junk bond issue in Europe alone reached an amount of $71 bn (€50 bn). At the global level, United States is a huge buyer of junk bonds. Before 2010, issuance of junk bonds reached a record $150 bn (€106 bn) only in 1998. Emerging markets find bonds an important term financing option due to limited availability of bank credit. Thus, their bond markets are also developing at a similar level to the equity markets.

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    What Are the Different Types?

    There are two major categories that junk bonds fall into:

    • Fallen Angels: These bonds fell from investment grade to junk bond status. The credit rating of the underlying company has decreased to low levels.

    • Rising Stars: These bonds are the opposite of fallen angels. Their ratings have increased due to the improvement in the credit rating of the underlying companies. As rising stars, they may still be junk bonds, but they are moving towards investment grade.

    To raise their credit rating, junk bonds are re-packaged differently to form collateral debt obligations (CDO). However, when the value of the underlying assets is extremely dubious, as in the sub-prime mortgage loans, they become toxic debt.

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    So How Do I Buy These Bonds?

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    Is investing into junk bonds for everyone? If you plan to buy junk, you should be mentally prepared to lose all the money you plan to invest. Obviously junk bonds are extremely risky. They also require basic knowledge and continued analysis of specialized credit. Wealthy individuals who have such resources have good reason to invest in junk. Another significant proportion of investors in junk is the institutional investors who dominate the junk market.

    Other individual investors can invest in a junk bond fund. These bond funds not only lower the risk by diversification, but they also benefit from research professional who track junk bonds on a daily basis. However, every investor needs to be aware of the time frame these bond funds require in order to mature. When one commits his or her money, they should understand how long it takes before they can sell them. Many funds impose restrictions on locking in an investors money for one or two years.

    Historically, returns on junk bonds have been 4-6% higher than U.S. Treasuries. To determine if it is the right time to buy junk, investors should look for the yield spread between the Treasuries and junk bonds. If it is lower than 4%, it is not the right time to invest. Another factor to consider is the default rate of these bonds. Rating agencies track the default rates and update their websites regularly. The year 2011 started with strong bids for junk bonds based on an optimistic economic outlook. Noticing the poor (3.4%) yield of U.S. Treasuries, individual investors began pouring money into mutual funds that focus on junk bonds.

    However, junk bonds are prone to cycles of boom and bust. They are no different from equities in that sense. These bonds gave staggering annual returns of 30% in the 1990s, but they are also prone to producing stunning negative returns.

    Some informed investors may find junk bonds valuable investments. Others may not. Regardless of one's intentions, it's important to remember that these bonds are high risk investments even though they may produce potential high returns.