A look at Junk Bonds

The term “junk bond” refers to corporate bonds from issuers that receive low ratings (BBB- and lower) from the bond rating agencies. Such bonds are also known as speculative or high yield bonds. Junk bonds have a higher risk of loss, either through from the issuer defaulting on payments, going bankrupt, or restructuring the bonds. To compensate for this, junk bonds usually pay higher yields than safer bonds.

Junk bonds rose to prominence during the leveraged buyout (LBO) wave of the 1980’s. Buyers would use junk bonds extensively to fund takeovers, then use the revenue from the acquired company to make the payments on the bonds. The success of such ventures led to increasing investment and higher risk takeovers. As risks increased, investors demanded increasingly high interest rates to keep buying junk bonds. Eventually companies started to default on their debt payments, investors stopped buying and the market collapsed, losing 25% of its value.

Junk bonds remained out of favor for much of the nineties due to the dot com boom and soaring equity prices, but made a significant come back when increased liquidity and low interest rates made speculative bonds more attractive again in the early 2000’s. Junk bonds and other debt were back in favor for buying companies, fueled by large amounts of private equity and hedge fund money. This cheap money boom continued until July 2007 when the sub prime housing market crashed and led to a credit crunch, which hit bonds hard as well.

While these boom and bust cycles demonstrate the volatility and risk of junk bonds, I believe that they do still have a place in the portfolio of many investors. The best way for most to get this exposure is in the form of a bond fund that includes junk bonds in its holdings. This dilutes the risk of having any one bond default, which is a very likely event over time. Buying individual junk bonds is definitely an investment to leave to the pros, or those rich enough to afford the loss!