Junk Bonds May not be so Junky

When you hear the term “junk bonds” you might be inclined to think that they are worthless; but don't let the term fool you or scare you away from these securities. Despite their name, junk bonds can be valuable investments for informed investors and may actually have a place in your portfolio because of their often higher yields. However, be warned- their potential high returns come with the potential for high risk.

From a technical viewpoint, a junk bond is exactly the same as a regular bond- an investor purchases a bond from a bond issuer with the assumption that the money will be paid back when the bond reaches its maturity date. What differentiates junk bonds from other bonds is their issuers' credit quality.

Most bonds are characterized according to their credit quality and given a bond rating by credit rating agencies (CRAs)- the "Big Three" CRAs being Moody's, Standard & Poor's (S&P), and Fitch Ratings. Bond ratings are expressed as letters ranging from 'AAA', which is the highest grade, down to 'C' and various combinations of these letters, in upper- and lower-case, depending on the rating agency. Higher grades are intended to represent a lower probability of default. So think of a credit rating as the report card for an issuer's ability to repay their debts. In general, blue-chip firms that provide safer investments have high ratings, while risky companies have low ratings. Based on their credit rating, bonds are classified into two broad categories- Investment grade bonds and Non-Investment grade bonds, also known as Junk bonds.

Investment Grade bonds are bonds issued by lenders that are deemed to be low to medium risk. A bond rating on investment-grade debt ranges from ‘AAA’ to ‘BBB-‘ according to S&P, or ‘Aaa’ to ‘Baa’ according to Moody’s. Companies that have manageable levels of debt, good earnings potential and good debt-paying records will usually have good credit ratings. These bonds may not offer huge returns, but the risk of the borrower defaulting on interest payments is much smaller.

Junk bonds are fixed-income instruments that carry a rating of ‘BB’ or lower on S&P’s scale or ‘Ba’ or lower according to Moody's. Bonds will typically receive a low rating when the corporation, municipality or other entity that issued the bond is facing financial trouble. In these cases, the credit risk on the bonds is fairly high, meaning that there is a greater probability that the junk bond issuer will have trouble fulfilling its repayment obligations. It is because these bonds have less-than-stellar credit ratings, that they usually offer high yields. Investors demand these higher yields as compensation for the risk of investing in them.

Junk bonds can be further categorized as either "Fallen Angels" or "Rising Stars." The former are bonds that were once investment grade but credit agencies lowered the rating when the company's credit worsened, while the latter are junk bonds whose ratings were raised because of their issuing company's improving credit quality. A rising star may still be a junk bond, but it could eventually become an investment grade bond.

The junk bond market is largely dominated by institutional investors, but individual investors also purchase junk bonds as a way to diversify their fixed income portfolios with bonds in different classes that provide for varied levels of returns. Mutual funds and insurance companies also invest in these high-yield bonds, with the insurance companies using them to fund annuities and other products they offer. Pension funds may also hold junk bonds in their portfolio, but the allocation is usually small because they are often subject to regulations that prohibit high-risk portfolios.

While junk bonds can actually be a savvy addition to a portfolio, they are not for everyone. Investing is all about risk and return. Junk bonds are usually purchased as speculative investments because, although investors rake in higher yields, they risk the chance that they never get their money back. They simply offer a better coupon rate due to the fact that they carry more risk. If you are willing to take the risk and want to invest in these bonds, do your research first, and, as with any high-risk investment, only allocate a portion of your portfolio to it. If understood and paid attention to, the reward of these high-yield bonds may very well be worth the risk.

Toni-Ann Neita is Assistant Vice President – Personal Financial Planning at Sterling Asset Management. Sterling provides medium to long term financial advice and investments in U.S. and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm