Let’s begin by taking the mystery out of junk bond investing. You are a successful author with money to invest. Your best friend is a renowned surgeon with excellent collateral and credit which is in need of $100,000 for six months so that he can buy a boat. You tell him you will consider it but that your wife’s brother wants to open a new business. He is also asking for a loan.|
Your brother-in-law has never been in business for himself. He is confident he can make it work, if only he can raise the capital, he needs to get started. Unfortunately, he owns very little collateral and his credit rating is poor. He may not have the assets to pay you back, but he offers you 4-5 points higher interest than the surgeon or any other investment you can make. It is your decision.
The brother-in-law is obviously a riskier investment than the surgeon. Lending the money to your brother-in-law is like buying a junk bond. Corporations behave much the same way by borrowing money in the capital markets. Corporations with good to excellent credit offer what are called investment grade bonds to raise capital at market interest rates. The others sell junk bonds at much higher yielding interest rates.
As for the borrowers – the surgeon and the brother-in-law, there is a different likelihood that the lender will get their money back. There is more risk in lending to the relative than to the surgeon, but the return is greater. This is the decision the bond buyer (lender) must make.
Corporations, like persons, have credit ratings. Corporations get their ratings from rating agencies like Standard and Poor’s and Moody’s. The rating is the agency’s opinion as to the corporation’s ability to repay their loans on time.
Bonds issued by companies rated AAA or Aaa are rated the highest or best risk for the lender (bond buyer), and downgrade through AA or Aa, then BBB or Baa, then BB or Ba and corporations with lowest ratings are considered “speculative grade” or “below investment grade.” These are junk bonds.
So, the question arises, why would anyone want to buy the riskiest, lowest rated bond from a corporation that may default? The answer? Money. The interest rate paid on junk bonds can be five or six points higher than on investment grade bonds. The promise of higher interest is the incentive to the investor.
Junk bonds are high-yielding bonds. The word junk’ does not have the same meaning as trash. Like any speculative capital instrument, whether stocks or bonds, buying junk bonds is a choice made by the investor. While it is all right for the wealthy surgeon to invest 10 percent of their financial assets in junk bonds, such an investment is not recommended for the average person working and saving for retirement.
Investors interested in earning the higher yields offered by junk bonds can reduce their risk by investing in high-risk/high-yielding bonds through mutual funds. This spreads their investment over a number of different bonds (corporations), thus reducing their risk of loss from defaults.
There is no mystery about junk bonds. A junk bond is no different from any other bond issued by a corporation. It is a loan from the investor to the corporation. The bond is their IOU that promises to repay the principal back by a stated maturity date, and a specified rate of interest paid on the borrowed money.
The decision to buy junk bonds should only be made after careful consultation with a financial adviser.