Junk Bonds - The Sexiest Investment

A Short & Simple Lesson in the Danger and Allure of Junk Bonds

You know you shouldn't. Your CPA wouldn't approve. Your wife would be furious if she found out. The guilt would consume you. Still, you can't help casting a lustful glance at junk bonds with their 10-12% coupons. Just remember flashy investments usually go up in smoke, and when these babies fall, they fall hard. They're called "junk" for a reason.
Lately, I've received a lot of emails about junk bonds and how (if) to invest in them. Here's a short and to-the-point lesson in what they are and whether you should add them to your portfolio.

The Fundamentals of Junk Bonds

Bond rating agencies such as Fitch, Standard and Poors, and Moody's assign ratings to debt issues. So-called investment grade bonds have a rating of BBB or higher. By assigning such a rating, the agency is saying that it believes, based on the company's current financial position, interest coverage ratio, and economic outlook, that the chance is default is not substantial. These issues often have a history of long, uninterrupted interest payments to bondholders.

Non-investment grade issues, on the other hand, are those that have been assigned a rating of BB or lower. These obligations possess a much higher risk for default or loss of principal. The companies that issue these "junk" bonds must somehow entice investors to risk their money. In order to do this, they offer a much higher coupon rate (e.g., 10%) than their investment
counterparts (e.g., 5 1/2%). Ironically, this increases the inherent risk because the companies that are least able to afford high interest charges pay double or triple their better-capitalized counterparts. Every bond in the world falls into one of two categories... investment and non-investment grade. There is a huge of difference between the two. Investment grade usually have a rating of BBB or higher. It is a safe bet to assume that they posses solid fundamentals, a stable balance sheet, and are not in serious risk of default or bankruptcy. Most have a long track record of making steady interest payments to their bondholders.

Junk bonds were tremendously popular in the generation of leveraged buyouts and corporate liquidations (otherwise known as the 1980's). Lately, they have staged a slight comeback with a potentially disastrous outcome. Small investors are buying them without fully understanding the risks they carry (and once they do figure it out, it will already be too late.)

Fallen Angels vs. Junk Bonds

In the course of business history, good companies have sometime experienced troubles that caused their debt ratings to be slashed. The company's bond issues plummet as a result. These type of issues are known as "fallen angels". They differ from junk bonds in that they were issued as investment grade and fell from grace. Purchasing fallen angels, if done intelligently, is far less speculative than acquiring junk bonds with the hope of holding them until maturity. This type of operation should be left to those who are able to evaluate a corporation's financials and reasonably estimate the potential outcome of the situation.
The Bottom Line on Junk Bonds
Avoid them like the plague unless you know what you are doing. If you do purchase them, do so with full understanding that unless you have substantial quantitative reasons to believe your purchase promises a safety of principal, you are speculating, not investing.