Even if you've never invested in them, chances are you have at least heard of the term ''junk bonds'' before, be it from the 1980s and Michael Milken, in movies like Barbarians at the Gate, or as part of so-called leveraged buyouts or LBOs, where investors pile a lot of debt onto the company they're buying. Yes, the junk bond, or high-yield bond, is truly a part of the fabric of American capitalism. But are they the right investment for you? That's the focus of the next installment of Investing 101.
What Is a Junk Bond?
The basic premise of a junk bond is predicated on the perceived ability of the borrower to repay a loan. Just like individuals have credit reports and FICO scores that affect their borrowing costs, so do businesses; and the lower the risk of default, the lower the interest rate you will be required to pay to get a loan and vice versa.
The difference is in the corporate world, credit ratings come in letter-grade form, rather than a numerical score, via ratings agencies, the biggest and best known being Standard & Poor's and Moody's. As the chart from Alphahunt below shows, the scale runs from AAA/Aaa to D, with any bond rated less than BBB/Baa falling into the junk or high-yield category.
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