Junk Bonds - What is a junk bond?

Summary: This article briefly answers the question 'what is a junk bond', and the yield and risk associated with these.

Related Articles: U.S. Savings Bond, bond trading, Treasury bills (T-bills)

What are 'Junk' bonds? These are more politely known as high-yield bonds - acquired the name as a consequence of their low rating by the major agencies and their high rate of default. 'Default' is the failure to repay principal and/or suspension of interest payments.

But a curious thing happened in the 1980s. Michael Milken examined the market carefully and determined that the default rate was unlikely to be as high on certain bond issues than was previously thought. The 'high-yield' market was born.

Of course, junk bond funds existed long before. Milken and others developed techniques for predicting with greater confidence which were and were not truly 'junk'. And, Milken's group encouraged the issuance of those bonds then profited from them - illegitimately so, some argued, which led to later legal entanglements.

The result has been: millions made millions by taking calculated risks on high-yield bonds.

Junk bond market

That's the key to prudent investing in high-yield bonds - calculated risks. Throwing darts blindfolded works less well in the junk bond market than in the stock market - where it already works badly.

Fortunately for those with the time and temperament to make the effort, research on bonds is available by the carload.

Junk bond rating

Step one is to get a junk bond rating from one of the major agencies, such as Standard & Poor's, Moody's or other. 'Junk' is distinguished from 'investment grade' (AAA/Aaa, AA/Aa, A/A, BBB/Baa) and carries a designation of BB or below.

But there are many steps after step one, including carrying out independent research on a company's current financial status and likely prospects, just as one would when buying stock. All the usual potential concerns exist: changes in prevailing interest rates, recession or high unemployment, technological changes obsoleting a company's product or service, limited liquidity, and so on.

Carrying out that research takes practice and guidance, but that too is available in abundance via simple Internet search. The diligent will quickly find advisors with a good track record, who make objective, moderately cautious statements about a potential buy.

And there are success (and failure) stories to learn from. In 1991, those who risked investing in lower rated bonds reaped the highest total returns: an average 34.5%. One year later, in a less outstanding year for bonds, junk debt took second place in the race for high returns, 18.2% compared to 22.4% return on convertible debt. 'Convertible debt' has more than one definition, but one example is the purchase of bonds which can be converted to common stock at the holder's option.

The example remains relevant today. In some categories, junk bonds or high-yield bonds constitute almost a third of the total issues. And, even at the lower figure, the returns challenge the average return on shares. Of course, nothing can beat those high flying stocks that some are lucky - or skilled - enough to pick.

What constitutes a high yield is relative to general rates of return, of course. But historically, anything above 8% or so would be considered very healthy and 15% exceptional. By comparison, the S&P 500 has an average return of about 12%, if the investor stays in for several years or even decades.

As with any high risk investment, the total portion in a portfolio shouldn't be more than 10-20% depending on the research backing the choice and an individual's tolerance for risk and potential loss of capital.