NUTS AND BOLTS OF JUNK BONDS
In the 1980s, junk bonds left a not-so-good impression to many investors. They associated these bonds with investment scams and high-flying financiers, including junk-bond leaders Ivan Boesky and Michael Milken. But, do you know that it can bolster a portfolio in certain ways? Here’s how.
Junk bond is a fixed-income instrument that carries a ‘Ba’ or below by Moody’s, or ‘BB’ rating or lower by Standard and Poor’s. Similar to a regular bond, this is an IOU from a company or organization indicating the following: principal (amount of money to be returned), maturity date (date it will pay back), and coupon (interest on the borrowed money).
These non-investment bonds pay high yield to bondholders since traders have no other option. And because it bears less than pristine ratings, it is difficult for them to acquire capital at an reasonable rate. It also has higher than average risk the corporation will default on the bond. Historically, average yields on these bonds have been 4% to 6% higher than US Treasuries.
Junk bonds are classified into two:
- Fallen Angels - From investment grade, their scores have been reduced to junk status because of the firm’s poor credit quality.
- Rising Stars - Rating has been escalated because of the company’s improving credit quality. Although still a junk bond, it is on its verge to being investment quality.
This bond is not for everyone. You should know a few things before asking the broker to purchase all the junk bonds he can find. First, you risk the chance of recovering your capital. Second, it entails a high level of analytical skills, specifically knowledge of specialized credit.
For most individual investors, who dominate the market, using a high-yield bond fund makes a lot of sense. It does not only enable you to take advantage of professionals who conducts research on junk bonds, but also lower risk by diversifying investments throughout different asset types. But before anything else, take note of how long you can entrust your cash before you decide to buy a junk fund. Many funds prohibit investors from cashing out for one to two years.
There are some instances returns of junk bonds do not offset the risks. To figure out its returns, individual investors look at the yield spread between junk bonds and US Treasuries. If the yield plunges below 4%, that might not be the best time to invest in junk bonds. They also look at the default rate on these bonds. One option is to check the Moody’s website.
Lastly, junk bonds are not that different from equities as it follow boom and bust cycles. Various bond funds, in the early 1990s, generated around 30% annual returns, but a stream of defaults can make funds produce negative returns.
Junk bonds in general have potential high returns, but high level of risk. Nevertheless, it can be a valuable instrument in your portfolio.
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