Are Junk Bonds Safe?
Junk or high yield bonds have certain risks that
their safer counterparts don’t. The tradeoff for this is
the potential for higher return. Here’s a look at
whether junks bonds are safe.
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 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
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
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.
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