Junk Bonds Explained

Junk bonds, high yield bonds or speculation bonds are just different names for the same type of investment instrument. Before 1977 a junk bond was an investment grade bond whose issuer had fallen on hard times or had their credit rating lowered. In 1977 Bear Stearns underwrote the first initial bond offering of a junk bond or a bond that started its life with a lower rating.

Bond ratings are essentially credit scores for businesses. AAA is the highest rating a company can have. D means that a company is in default and is unable to pay its principal, interest or both on the bonds that it has issued. The higher the rating the more likely it is that the bond will hold its value over time and maintain the ability to pay its coupon rate on time.

Many companies’ rate bonds for various reasons but the top three in the US are Standard and Poor’s, Moody and Fitch. They may not always give the same rating for a bond so it is good to check a bond’s rating on all three lists. Currently in August of 2007 there are only 9 companies on the New York Stock Exchange that are rated as AAA by all three services.

These companies not only give the bonds a current rating, but maintain watch lists to forecast the expected movement up or down of a bonds rating. The trade on bonds is a global market and the rating groups have offices worldwide.

Bond Rating System

AAA-AA Bonds of high investment quality with little to no risk.

AA-BBB Bonds of medium investment quality with little risk.

BB-B-CCC-CC-C Junk bonds or low grade investment quality with a high
Risk attached. C being the highest risk, BB being not to

D Bonds that are currently in default for nonpayment of
Principal, interest or both.

Because of the increased risk these bonds pay out at a much higher rate. Many people prefer to invest in a fund which buys many junk bonds and spreads the risk as opposed to individual junk bonds.

Rates change daily but here is a snapshot to give a comparison
10 year AAA corporate bond average of 5.41% return
10 year average gain for Standard and Poor’s 500 is 10.7
Credit Suisse High Yield Bond Fund yield of 11.9

Over that ten year span the corporate rate fluctuated only slightly. The Standard and Poor’s 500 moved a little more but always stayed within two points. Credit Suisse Bond Fund went on a bumpy if not exactly wild ride starting at 10 %, dropping to 6.75 before rising to 14% in June where once again it took a dip. More risk, increased volatility.

Today’s investor in junk or high yield bonds may be hoping for the next Google, or even Microsoft. Some would seek to add a high yield high risk element to enhance an overall portfolio. Still others might choose junk bonds for the higher coupon rates to create a higher, albeit riskier income stream.

Will they be junk or high yield? Well that’s part of the game. If you are taking the ride for the first time it is probably best to go through a well established high yield bond fund. This incurs less out of pocket and of course less risk. If you love Vegas, live life on the edge and can stand to loose then take a chance pick out a bond or two and good luck.