POSSIBLY the least attractive name in investment terminology is “junk bond” – it doesn’t exactly conjure up images of success and wealth. Nonetheless, junk bonds can contribute towards both these aspects: they form an integral part of many successful portfolios, thus helping increase your wealth.
The term “junk bond” is actually a rather unkind description, and they certainly have nothing to be ashamed of – so much so that they are often referred to as “high yield bonds”, which presents a completely different image.
What are junk bonds?
From a technical point of view, a junk bond is the same as a regular bond. All bonds are debt issued by companies or governments wanting to raise money. In return for lending them money, they promise to pay you a set amount of interest each year and to repay the cover price at a certain time in the future.
There are different categories of bonds, which are classified and graded according to the credit worthiness of the issuing organisation. The two leading rating agencies are Standard & Poor’s and Moody’s.
Bonds classified as BBB or above are “investment grade” bonds; those BB and lower are considered “speculative” or “non-investment grade”…or “junk”. Hence the term “junk bonds” refers to those which don’t make investment grade. When these classifications were first developed, speculative grade bonds developed negative connotations and became known as “junk” because many people would not accept the risk of owning them.
As time went on, however, the advent of modern portfolio theory highlighted the need for diversified asset allocation, and financial researchers began to observe that the “risk-adjusted” returns for portfolios of junk bonds were quite high. In other words, the credit risk of these bonds was more than compensated for by their higher yields.
These bonds went through a bad time in the late 1980s, but recovered in the 1990s with an increasing variety of high yield issues being released. Today, they are mainly issued to provide working capital for growing companies, and numerous brokers and banks participate in this market, which has developed into a more liquid, diverse and credible one.
The market has broadened to include many issuers with diverse needs, and junk bonds can be broken down into two categories:
Fallen Angels – This is a bond that was once investment grade but has since been reduced to junk bond status because of the issuing company’s poor credit quality.
Rising Stars – The opposite of a fallen angel, this is a bond whose rating has been increased because of the issuing company’s improving credit quality. A rising star may still be junk bond, but it is on its way to being investment quality.
Why buy junk bonds?
As with other forms of investments, the lower the risk, the lower the potential return…and vice versa. Because non-investment grade companies cannot offer security, they offer a higher yield to encourage investors to buy their issues. Their higher credit risk means that junk bond yields are higher than bonds of better credit quality. Hence their other name, “high yield bonds”. Studies have demonstrated that portfolios of high yield bonds have better returns than other bond portfolios.
The benefits of owning high yield bonds include:
•A high rate of income
•The potential for capital appreciation
•More security than equities (if a company is liquidated, bondholders have
priority over stockholders)
•High yield bonds are less affected by increasing interest rates than
investment grade bonds. They perform well during times of economic
growth as there is less chance of default.
Who should own junk bonds?
High yield bond investment relies on credit analysis, which concentrates on issuer fundamentals and a “bottom up” process. It requires a high degree of analytical skills. While it offers many benefits, it also carries a certain amount of risk. Most individual investors, therefore, are best advised to invest through a high yield bond fund.
Not only do these funds allow you to take advantage of professionals who spend their days researching bond issues and companies’ credit worthiness, but they also allow you to lower your risk by diversifying your investments across different grades, sectors, countries and currencies.
Depending on the fund, you can often choose whether to receive interest payments quarterly, half-yearly or annually. If you do not need the income you can opt to reinvest the income in the fund, thus enjoying accelerated growth rates. From a tax point of view, this is attractive as it means you can accumulate incomes and gains free of taxes.
Some may call them “junk bonds”, but considering the benefits they offer, this is not very apt. I prefer to use “high yield bonds”. As with all investments, do seek independent financial advice before buying these bonds. Make sure you understand the downsides as well as the upsides, and ascertain that they are suitable for your circumstances. Many people have benefited from this form of investment, particularly over the last few years. Perhaps it’s time to find out if they could work for you?
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