Junk Bonds Explained

A junk bond can be a sound investment, as long as you own a bond fund, and have an understanding of what they are and how they work. A junk bond is basically the same as a regular bond, though with a few differences. It is basically a version of an IOU; a company or organization makes a promise that it will pay you back on a certain date including interest. Some common terms to remember are principal, the amount you will be paid back; maturity date, the date they will pay you back; and coupon, the interest they will pay.

Junk bonds pay high yields, but only because the borrower has no other option. The borrower will most likely have bad credit, and their low credit score prohibits the borrower from finding a less expensive option. Because of this, junk bonds have a higher risk of the borrower defaulting on the bond. There are also two types of junk bonds; fallen angels, and rising stars.

At the fallen angel level, the bond has been reduced from average level to junk bond status because of the company’s poor credit rating. The rising star junk bond is slightly better than the other option. This junk bond is rated better because the company has improved its credit rating, and may be close to achieving investment quality.

Before buying a junk bond, there are some things you should know. While it may seem like a good investment, the risks associated with the bond are extremely high. There is a better than average chance that you will not receive any of your money back, hence their name junk bond. The junk bond market is also used primarily by institutions, meaning that it may be difficult for the average investor to find a lower risk junk bond.

As an individual, buying a junk bond is a high risk investment that can take a long time to pay off, if it does at all. Investors are usually given a set amount of time, often 1-2 years before they are allowed to cash out, or see any of their money back. In that amount of time the company may have seen a rebound, but they may also have fallen into a worse financial situation, including bankruptcy.

A typical bond is graded on descending level, with the highest bonds rated as AAA. Junk bonds are usually rated BBB or BB, because they are known as a speculative grade meaning they have a greater risk of default. This high risk and low payout level has caused some investors to shy away from junk bonds, and some investment firms or dealers will still not take the risk.

When considering investing in junk bonds, it is important to remember that a well known and reputable company may recover from a negative or poor credit rating. Large corporations including IBM and General Motors have at one point or another, had a low credit score that hurt their investments, but recovered nicely. Other companies such as Time Warner, have also had problems recently. If the company is a well respected one, the high risk is slightly offset by their history and reputation.

Junk bonds can be a good investment, but investors are wise to fully examine all the risks associated with the bond, and the company’s history before making a decision.