Junk bonds are bonds that the experts feel have a higher than average chance of being defaulted on. Also commonly known as high yield bonds they pay higher yields to bondholders because the borrowers unfortunately have very limited options.
All bonds are characterized and rated according to there issuers credit quality and therefore fall basically into one of two categories of bonds:
1) Investment Grade Bond – low to medium risk investment.
2) Junk Bond / High Yield Bond – high risk, high possible return on investment,
A junk bond is similar to a regular bonds but junk bonds differ because of the credit rating of their issuers. Think of a bond rating as the report card for a company’s credit rating, safer investments have a high rating while risky companies have a low rating.
A bond is basically an IOU from a corporation or organization that states the amount it will pay you back, the date it will pay you back, and the interest it will pay you on the borrowed money.
The highest quality bonds are rated AAA, ratings below BBB are considered junk bonds, You might ask yourself why they are still so popular? Well, a bond with a AAA rating might pay 7 percent per year, while a junk bond could pay as much as 13 percent which allows bold investors the opportunity to cash in.
Junk bonds can be broken down into two basic categories:
Fallen Angels – This is a bond that was once investment grade but has since been reduced to junk bond status because of the issuing company’s poor credit quality.
Rising Stars – The opposite of a fallen angel, this is a bond whose rating has been increased because of the issuing company’s improving credit quality.
Back in the 1980’s junk bonds were invented to enable smaller companies or big investors to use bonds and bond markets to finance and plan takeovers of large corporations.
The original concept was legal, but overly aggressive stockbrokers aided by large investment firms, exploited and corrupted it, and they used illegal inside information, deliberately-planted misinformation and market rigging to make millions and millions of dollars.
This led to the Drexel-Burnham saga, where Michael Millken led a major investment charge into junk bonds in the late 1980’s, which ended up in scandal and federal indictments with many of those pirate multimillionaires in the penitentiary.
With that shameful era behind us, nowadays junk bonds are perceived to be legitimate, but risky investments at most. A research study completed in mid-1989 by Harvard professor Dr. Paul Asquith found that an incredible 34% of all high yield bonds defaulted.
So you can see the risk involved, junk bonds are a very tentative investments which require expertise in the field of bond investment, and are not recommended for beginners or conservative investors seeking secure and supportable income.
Unless you are an investment guru, then the safe course is to stick with investment grade bonds and make a more conventional yield on your investment, and avoid the high possibility of loosing your shirt.