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.

Understanding Bond Duration

Holders of bonds face a distinct set of risks that may be less obvious to the uninitiated. Thankfully, one of the biggest risks in the bond market - interest rate risk - is easy to determine, using a concept called duration. It's possible to approximate how much a bond's price is likely to rise or fall when interest rates change, a level of certainty that stock investors will appreciate. So before you go out and buy a 30-year Treasury bond in the mistaken belief that it's risk-free, consider its duration.

A Basic Bond

Before diving in, let's take a simple example of a company that wants to borrow $100. It issues a bond that it sells for $100. To attract investors, the issuer of the bond offers to pay $4 a year to holders of the bond, and will do so for 10 years. At that time, the bond matures, and the bold holder gets $100 back. In the parlance of the world of fixed income, we can say that the bond has a face value of $100, a coupon rate of 4% and a maturity of 10 years.

There are many risks to the holder of the bond. The best known may be the risk that the issuer of the bond can't afford to make interest payments or return the principal. But a default, as this scenario is known, isn't the only risk.

Interest Rate Risk
But even a bond with virtually no chance of default - for instance, bonds issued and backed by the US Government - still have risks. Going back to our simple example, let's say that the day after the bond is issued, interest rates rise to 5%. The owner of that bond might kick herself. If she had waited a day, she could have bought a bond that paid 5% a year. That makes her bond less valuable, and this will be reflected if she tries to sell the bond to someone else. She may not be able to get back her $100.

The seesaw relationship between interest rates and bond prices is a fundamental concept of bonds. But some bonds have greater sensitivity to changes in interest rates. Bond investors don't have to guess at this exposure. A bond's modified duration, a figure derived from several factors, measures this risk and tells the investor how its price is likely to change when market interest rates go up or down. A bond with a duration of six years would be expected to fall 6% in price for every 1% increase in market interest rates.

Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.

Here are some of factors that affect a bond's duration:

· Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.

· Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Using Duration to Your Advantage

Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:

· Speculating on interest rates: Investors who anticipate a decline in market interest rates - as a result of, for instance, a simulative rate cut by the Federal Reserve - would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.

· Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.

Calculating Duration

Start by determining the value of a bond's yearly cash flow, adjusted to give greater value to payments that are made sooner rather than later. Divide that figure by its price to calculate its duration. Online calculators make this easy.

Bonds 101

What Are They?

Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house; a broom for example. Although you get your paycheck the next day, you ask your shopping buddy to borrow a few dollars so you can purchase the broom now, in return for which you will not only pay them back tomorrow, but buy them dinner as well. Your friend, finding these terms acceptable, loans you the money and you purchase the item.

This is, in essence, what happens in the corporate world when a company issues bonds. Generally, as a business grows, it doesn't generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. Because of this, most businesses have one of two options. They can either 1.) sell a portion of the company to the general public by issuing additional shares of stock, or they can 2.) issue bonds. When a company issues bonds, it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. In essence, it is the same thing as a mortgage only you, the investor, are the bank.

Why Would Anyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.