Junk Bonds Explained

A bond is simply another word for a loan. A bond is just about anything that has a
a) principal amount, which is the initial loan
b) coupon, which is the interest payment, to be paid usually on a biannual basis, though it can differ from one case to another
c) maturity date, which is the date the principal amount will be repaid in full

You can think of your mortgage and your credit card debt as bonds that you have sold to the bank and the credit card company, respectively. To take the analogy a bit further: every person has a credit score, which is a number value that represents the likelihood that they will default on their obligations; in non-jargon, your credit score tells banks how safe it is to loan you money.

Banks, corporations, and governments also have a credit score, of sorts, assigned by the bond rating agencies Moody’s and Standard and Poor. Every bond sold on the markets is rated on a scale from (highest to lowest) AAA to D, where anything above a BB is considered “investment grade”. An investment grade bond is one that is rock-solid, and should always pay out in full. Once you dip below BB, you start dealing with the sub-prime mortgages of the bond world: the junk bond.

Junk bonds are bonds that are considered substantial risks by the credit rating agencies. Investing your money in these is a hit-miss thing, and the likelihood of a miss increases the lower the rating is. To compensate for the fact that, to put it frankly, you might lose all your money, the company selling the bonds will promise a massive coupon (i.e. a very high return on investment) should it actually wind up being able to pay you back.

Whether to invest in a junk bond is a matter of personal choice, but the risks must be taken very seriously. Junk bonds are not a way to make quick cash. The only reliable way to make any money at all in junk bonds is to use a technique serious long term investors use: do an analysis of which junk bonds are rising in the ratings, and therefore actually safer bets than they appear, and which are falling, and therefore less safe. The former is dubbed a “rising star”, the later a “falling/fallen angel”.

Even among the rising stars, a junk bond remains a junk bond, and you might never see a penny of your investment. However, you now have a higher chance of earning money in the long term, and of tripping of a hidden gem, like the next Microsoft or Google.

I would like to end with a warning: if you are reading this article because you need to have junk bonds explained to you, you should not be investing in them. Wait a few years, invest in some investment grade bonds, and learn more about the details of the junk bond you are interested in. Talk to professionals, do your research, and then consider buying them.