Junk bonds are speculative but investors find them attractive as credit risk can be more than compensated for by their higher yields. But most individual investors should steer clear due to the high minimum size of bond trades and the specialist credit knowledge required.
What are Junk Bonds?
Junk bonds, or high yield bonds, are issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered “speculative” grade or below “investment grade.” This means that the chance of default with junk bonds is higher than for other types of bonds. Their higher credit risk means that their yields are higher than bonds of better credit quality. Portfolios of junk bonds usually have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk.
Characteristics of Junk Bonds
Credit Quality and Investment Grade
Junk bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit rating agencies created a grading system to reflect the relative credit quality of bond issuers. The highest quality bonds are “AAA” and the credit scale descends to “C”, and finally to the “D” or default category. Bonds considered to have an acceptable risk of default are “investment grade” and encompass “BBB” bonds and higher. Bonds “BB” and lower are called “speculative grade” and have a higher risk of default.
Independent regulators soon began to use this demarcation to establish investment policies for financial institutions, and government regulation has adopted these standards. Since most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They soon became known as “junk” since few people would accept the risk of owning them.
The advent of modern portfolio theory meant that financial researchers soon began to observe that the “risk-adjusted” returns for portfolios of junk bonds were quite high. This meant that the credit risk of these bonds was more than compensated for by their higher yields, suggesting that the actual credit losses were exceeded by the higher interest payments.
Underwriters, being creative and profit-oriented, soon began to issue new bonds for issuers that were less than investment grade. Many mutual funds have been established that invest exclusively in high yield bonds, which continue to have high risk-adjusted returns.
Investing in Junk Bonds
Investment in junk bonds relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a “bottom-up” process. It is concentrated on the “downside” risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group and by issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds.