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.
What Are the Risks?
As you might expect, junk-rated companies, below investment grade, have to pay a lot more to borrow, which means investors in their debt demand a high-yield for the additional risk they are taking.
"It has an unfortunate name,'' says Bob Levine, author of the book, How to Make Money With Junk Bonds, but explains the asset class is well established and can offer extremely enticing rates that "currently run as high as 10-12%." Compare that to a 10-year U.S. Treasury which currently yields about 1.6% and you get the idea why risk-tolerant investors would be interested. The gap between the yield of a Treasury and a particular junk bond is known as "the spread." The wider the spread, the higher the chance that you don't get paid.
How Do I Invest in Junk Bonds?
While there are literally thousands upon thousands of different corporate bonds, with all levels of credit ratings, available in the market, individual investors typically invest in them via an ETF or mutual fund. From Levine's standpoint, he says he "would prefer to have an actively managed fund where the manger has discretion" rather than an index-linked find that simply owns every bond in a particular benchmark.
He explains that his years on Wall Street and background as an analyst have left him in favor of a "total-return" methodology in which a high current income plus a capital gain are the objective, versus the route some funds take, which is to ''swing for the fences'' and simply chase the highest yields.
How Much Money Should I Commit to Junk Bonds?
Of course, risk tolerance and suitability are personal questions that must be dealt with individually or with a financial adviser, but putting an exact percentage on it is difficult. Levine says ''certainly not a lot, not a huge percentage" but at least some of your risk assets should be in high yield. He says, for example, many pension funds buy high yield debt as a way to help meet their liabilities.
Just like with stocks, there is a seemingly limitless amount of research and analysis that can be done on high yield corporate bonds, and their yields and prices can be affected by a number of factors. In short, it is not an investment to be made lightly, but with the right amount of research, as well as some reasonable luck and good timing, junk bonds can play a valuable role in meeting your long-term objectives.