Junk Bonds Explained

Junk bonds are an underrated and often misunderstood investment tool. The name simply means that the bond is issued by a company that has a higher credit risk and a lower bond rating, so it becomes a “junk bond”. There is a history to the term “junk bond” but the basic idea is that companies with lower bond ratings issue junk bonds to raise money for capital-intensive projects – basically the same reason that other companies issue traditional bonds. Junk bonds have the potential for a consistently higher yield, or average rate of return for a given investment than bonds from companies with higher ratings.

How are bonds rated? Bonds are given a rating by a third party that reviews the potential risk for non-payment (or “default”) by the company that issued the bond. “Default” simply means that the company is at a level of high risk and cannot meet it’s obligations to existing bond owners. Bond ratings are determined by a host of interrelated factors but the basic idea is that companies with higher bond ratings are considered more financially stable and thus desirable for investors.

Companies with higher bond ratings are considered solid investment opportunities because these companies have met their obligations for a measurable period of time. The ratings system itself is simple for consumers to understand – AAA is generally the highest rating, followed by AA and A, then BBB and so on down to “default” or D. Investment grade bonds are issued by companies with higher ratings and junk bonds are typically issued by companies with lower ratings.

However, buying a bond from any company simply means that the company issuing the bond has made a promise to pay you back within a given time frame (called the maturity date) for the amount invested. The amount invested is also termed “the principal”, and the interest or “coupon” of the bond is how much interest you will earn during the time you own the bond.

Junk bonds are usually issued by companies with less than an average BBB bond rating. These companies may not have met their obligations for a period of time so simply reviewing the rating of the company may not be enough to determine whether or not it’s a good idea to purchase a junk bond. Also, some of these companies do not fall into the stable rating and equity patterns of more established companies with solid profiles.

When uncertain about the reliability of a particular company, background information as well as overall performance history on the company and their reason for issuing the bonds should be reviewed prior to deciding whether or not to invest in a particular bond series. Investment is all about risk and one way to mitigate or reduce risk is to research the company before buying the product.

What do bond ratings and credit risks mean to the Jane or Joe Average Investor? Investors need to realize that no single magic bullet exists for a perfect investment vehicle. AAA rated companies issue bonds that may produce similar earning results over long periods of time but BB bonds may produce a higher yield amount during critical periods of the investment cycle. And there is no guarantee that companies issuing junk bonds will earn higher than market average yields.

What investors need to do is mix high risk, medium risk and low risk investments depending on their individual investment goals. Junk bonds are not for everyone, but they can be an important tool for someone seeking to risk a small percentage of their overall portfolio for the potential of higher earnings.