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One of the great financial tools for companies today is the ability to gain financing by issuing debt. Investors access this debt through corporate bonds, which is bought and sold all over the world. Companies strive to get this best credit rating on their debt, which is issued by agencies like Moodys. The best rating is AAA; very few companies ever get this rating. A single C, or sometimes D, is the lowest grade possible. Although the name implies these bonds are worthless, junk bonds can provide rich rewards for the careful investor.

What are Junk Bonds?

Junk Bonds, or High-Yield Bonds as they are called today, are corporate bonds who rating says they aren’t investment quality. This means they have a bond rating lower than BBB. The term “junk” can be a misnomer; companies who issue high-yield bonds just have a higher risk of not repaying their bonds because their chance of bankruptcy is higher. In return for taking the increased risk, junk bonds also pay a higher interest rate than most “safer” bonds. This higher interest rate makes these bonds attractive to investors.

History of Junk Bonds

Before the 1980’s, very few people paid attention to junk bonds. Because bonds were seen as conservative investments, junks bonds looked too risky for conservative investors. However, in the 1970’s, Michael Milken discovered that junk bonds were under priced and a diversified portfolio of these bonds would outperform the market. When Milken went to Drexel Burnham Lambert, he used junk bonds to fuel the leveraged buyout boom of the 80’s. Wall Street became awash in money, until an insider trading conviction brought Milken down. Today, junk bonds are still used for takeovers and can be combined into other bonds, like mortgages, to increase their rating.

Investing in Junk Bonds

There are several things to look at when considering investing in junk bonds. While the high interest rate and discounted price may make any junk bond look attractive, any investor who doesn’t separate the wheat from the chaff will lose money. First, examine the company who issued the debt. Does the company have an issue with repeated bankruptcies? Is the company maintaining or increasing revenues or is it losing money? A company losing money will probably have trouble paying its debt off, causing investors to lose out. Also, make sure the company isn’t overloaded with debt. More debt means business conditions will suffer, and the company will again have a hard time paying the interest payments. Second, look at market conditions. While it’s hard to predict future economic conditions, a down market hurts risky assets more than any other class. Then again, the price volatility caused by a downturn could create an investment opportunity.

Junk bonds have played an increased role in the modern economy ever since the 1980’s. They give investors a way to increase their chance of high reward my taking a higher amount of risk than conservative bonds and blue-chip stock provide. Still, investors should be warned that investing in junk bonds is very risky. The companies who issue them have a higher chance of bankruptcy than many companies. Still, for those who can handle the risk, the rewards can be great.