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What is a Junk Bond ?
Like any other bond, junk bonds are
also regular IOUs issued by a company or organization. The
difference is in their credit quality. The credit ratings for
bonds are provided by Standard & Poor's, Moody's Investors
Service and Fitch Investors Service.
These agencies provide a grading system that rate the bonds
starting from 'AAA' (highest investment quality) and ending at
'D' (default payment).
All bonds are categorized according to these ratings and
generally, you will find that bonds fall into one of the
following two categories:
Investment Grade bonds are rated BBB and higher. These bonds are
usually issued by blue chip companies. While investment grade
bonds might not offer huge returns, the risk is much smaller an
is a much safer bet for investors.
Junk Bonds are also called as “high-yield bonds” because they
pay high yields to the investor. Junk bonds are typically rated
at BB/BA or less. Although these bonds pay higher returns, there
is a much greater chance of payment default. As a reason, these
are also known as “speculative” grade bonds.
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The credit rating of a company is
based on a number of factors like the nature of their business,
their financial holdings, their employees, and the length of
their existence. Low-rated corporations need the income from the
bonds so they offer higher returns on them. The credit ratings
measure how risky it is for the investor – will the issuer be
able to make interest payments or repay the principal. Some of
the largest US corporations such as IBM and General Motors were
at times below investment-grade rating. The bonds of companies
with revenues of $35 million or less are rated non-investment
grade or junk. What this means is that the companies must pay
higher rates of interest on their bond issues compared to
investment-grade bonds. That is why these bonds are also known
as high-yield bonds. Due to this system of rating, mainstream
investors and investment dealers did not deal in bonds that were
rated “BB” or less. Thus, they became known as "junk" since very
few people took the risk of owning them.
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There
are two kinds of junk bonds
• Rising Stars are stocks of a company whose credit rating is
improving and is on its way to becoming investment grade.
• Fallen Angels are stocks of companies whose credit rating has
fallen due to various reasons. These bonds were once investment
grade quality but have since fallen, hence the name.
Think of junk bonds and the name Michael Milken immediately
comes to the mind for many investors. He was known as “junk bond
king” in the early 1980s because he used high-yield junk bonds
for corporate financing, mergers enormous personal fortune, but
in 1989, he was convicted after pleading guilty to charges of
securities fraud. As a reason, junk bonds became associated with
scandal and ill-repute.
But with the advent of modern portfolio theory, investors began
to see that the returns for junk bonds were quite high. The
higher interest rates of these bonds more than compensated their
risk factor. Many mutual funds invest exclusively in high yield
bonds with average yields on junk bonds being between four and
six percentage points above the U.S. Treasuries.
Important facts to know about junk
bonds
• They are high risk - you risk the chance that you will never
get back your money.
• It requires a high degree of analytical skills including
knowledge of specialized credit.
• You can lower your risk by diversifying your investments
across different types of assets.
• Many junk bond funds do not allow investors to cash out before
a minimum of one to two years.
• The yield on junk is usually between 4 and 6% above
Treasuries. If the yield spread shrinks below 4%, then it might
not be the right to invest in junk bonds.
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Article Contributed By: Jaya Suresh
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