Warning: I am by no means making any sort of investment suggestions when it comes to where you put your money. Each of us has different goals in life and situations are certainly not the same for any of us.
Now that that's out of the way let's get to the subject at hand.
Junk bonds are just as the name implies. They are typically rated well below established investment grades and while they might carry a higher rate of return than your typical Treasury or Corporate bond, they carry a much higher degree of risk. This is because the issuer of the bond has a lousy credit rating and the likelihood of them defaulting on both interest and principal payments is much higher. They are not for the faint of heart but if you’re willing to roll the dice and invest your hard earned money in them, you might just turn a profit. Then again, you might not.
To more sophisticated investors the following might be a bit redundant but in order to do this w/u justice I figured I’d start at the beginning.
First of all, when you buy a bond you’re basically making a loan to the issuer. Some of the proceeds of the bond might be earmarked for a specific purpose such as expansion of the company into new markets or they might fall into a “general purpose” category. Before purchasing a junk bond you should do your homework or consult an investment advisor.
Some of the things you should look at are how the company stacks up against their competitors in the same industry. If they’re near or at the bottom of the list, that should trigger some warning signals off in that thing you call a brain and your money would probably be better off somewhere else.
Another thing to look at is the maturity date. That’s the date that the company is obligated to pay back the principal amount of your investment as well as the final interest payment. How long do you want to have your money tied up? Of course, you can always try and sell the bond before that date arrives but if the company is in the crapper chances are you aren’t going to find many takers and even if you do you’ll most likely be staring at a significant loss.
Unlike your run of the mill investment grade bonds, junk bonds are more apt to fluctuate in price due to market conditions. This is especially true when a recession occurs and interest rates are plummeting. During that time, companies usually are struggling just to make a profit so they can pay their employees and other overheads rather than pay off their investors.
During the recent financial crisis many so-called investments took on a new name. They were called “toxic assets” because their value had dropped so low that nobody would touch them. Some of those included junk bonds that were prepackaged into what is known in the industry as “collateralized debt obligations” (CDO). I won’t get into the nitty gritty of what those investments entail but a short description would be that they are a bundle of bonds with varying degrees of credit associated with them with and with different length to maturity. By staggering them in such a manner the bonds with the higher credit rating would offset the junk bonds in the portfolio and thus make them eligible for big time investors such as mutual funds and pension plans.
In hindsight, that didn’t work out so well. All you have to do is take a look at the fall of Lehman Brothers to get an idea of what happens when one company assumes too much risk.
So there you have it. If you’re not squeamish about where you put your money, junk bonds might just be the thing you’re looking for to round out your portfolio. As for me, I’d never put my eggs in one basket, especially one that included investing in junk bonds. I’d rather take my chances in Vegas first.
As always, when looking to spend your hard earned money or where to put your life savings, caveat emptor!
Written in accordance with the terms and conditions set forth under Section A. Article 2. Subparagraph 6 of A BUSINESS PROPOSITION QUEST 2012.
Source(s)
30+ years in the financial services industry.