The phrase ‘junk bonds’ conjures up pictures of throwing money into a fire perhaps, and that is totally undeserved. Junk Bonds are bonds that are rated as AAA, AA, A BBB, BB, B, CCC, CC, or C. Another rating is D, but bonds with a D rating are literally in debt. Investment grade bonds are rated at BBB or above. Government bonds are rated at AAA since they are virtually risk free. Only in the event of a government collapse would those bonds lose value. This is in reference to US government bonds, other countries can also issue bonds and depending on their stability, those bonds could have any rating.
Junk bonds are also known as speculative bonds or high yield bonds, because they typically have higher returns than investment grade bonds. They do have less stability than investment grade bonds, so many people will avoid them for that reason, however many investors do buy junk bonds because the rates of returns are much higher than investment grade bonds.
Another reason why some view junk bonds as no good is because some investors and funds are prohibited from investing in them. These investment restrictions are often written into bylaws to prevent funds from losing balance and not having the desired levels of diversity.
Junk bonds are just like any other type of bonds in that they are issued generally from a corporation trying to raise funds. The bond is a sort of corporate level IOU and there is a pre-determined period of time that the buyer holds the bonds and then when that time expires the corporation will pay back the face value of the bond. In the mean time the holder will be given interest payments, otherwise known as the ‘yield’ of the bond. Bond periods are determined by the issuer and the rating is based on their credit. As an informal rule the worse the credit rating the higher the interest rate paid.
Some companies when trying to raise funds for capital projects will issue bonds which will be rated in the ‘junk’ category. This happens because the companies may not be in a solid position financially and it leads to the company being viewed in an even worse light. To relate this to something we all may deal with; when a person is issued a credit card and makes on time payments for a few years and then loses their job, overtime or has to take a pay cut, they may end up having a payment go out late. This in turn can increase their interest rate and then their minimum payments end up higher. The person is in no worse a situation as far as their income goes, but suddenly one or more of their payments are increased and then their whole financial situation can unravel.
This is the same thing that companies issuing bonds can go through. They have plans for improvements or – worse case scenario – need funds to make it through a slump. Their bonds are slow to sell because of their financial condition, and then become viewed as junk bonds. This causes the sales to slow even more and then they could end up in worse shape. Not all junk bonds are created equal, and not all of them deserve the label.
Word to the wise, unless you really know what you are getting into, you should avoid junk bonds unless you first conduct extensive research.