Junk Bonds Explained

Junk bonds or speculative bonds are common term used for bonds that are rated below investment grade by the three major investment rating companies: Standard & Poor’s,Moody’s,and Fitch.

Each company employs its own methods and rating labels for bonds issued in the market.For example,Standard & Poor’s rates bonds,from highest investment grade to lowest,as followed: AAA, AA, A, BBB; meanwhile,Moody’s rates: Aaa, Aa, A, Baa.

Bonds below this grade are considered speculative or junk.Standard & Poor’s rates junk bonds from highest rating to lowest as followed: BB, B, CCC, CC, C and Moody’s rates as these: Ba, B, Caa, Ca, C.

Ratings can be adjusted slightly by “+” or “-” signs in Standard & Poor’s Scale or by number “1,2,3” as in Moody’s Scale.So, B+ is higher than B, B- is lower than B or Moody’s B1 is higher than B2, B2 higher than B3.

In general,the rating of a bond reflects the level of credit risk (default risk) associated with that bond;thus,the higher the rating is the lower the default risk,and vice versa.In compensation for the risk usually junk bonds give a much higher yield than a comparable high-rated ones.For example,a 10-years A-rated bond issued by Toyota Motor Company has a 6% yield while a 10-years B-rated bond issued by General Motor Company has 11% yield.

Though risky junk bonds have their own place in a bond portfolio.They act as an income booster due to their handsome regular interest payments and the potential of capital appreciation if the bond’s rating is up-graded and/or the market interest rates falling (bond price goes inversely with interest rates change).Furthermore,a well-calculated portion of junk bonds in a diversified bond portfolio can improve the portfolio return without sacrificing its safety.Consider this example:
A portion of Fund A has $100,000 invested in junk bonds with an average yield of %10 and a probability of default rate is 5%.
A portion of Fund B has $100,000 invested only in high investment grade bonds with an average yield of 4% and 0% probability of default.After a year:
Fund A: Interest payments received…… $10,000
Default amount (loss) ……- $5,000
Net…… $5,000
Fund B: Interest payment received ……. $4,000
Default ….. $0.00
Net….. $4,000
So Fund A outperforms Fund B $1,000.
Fund A looks more risky than Fund B but actually,by scientific probability,it doesn’t.
More information about bond ratings are available on the websites of Standard & Poor’s,Moody’s,and Fitch companies.

Author does not own any company securities mentioned in this article.