Everything You Need to Know About Junk Bonds

The term "junk bond" can evoke memories of investment scams such as those perpetrated by Ivan Boesky and Michael Milken, the junk-bond kings of the 1980s. But if you own a bond fund today, some of this so-called junk may have already found its way into your portfolio. And that's not necessarily a bad thing.

Here's what you need to know about junk bonds.

Like any bond, a junk bond is an investment in debt. A company or a government raises a sum of money by issuing IOUs stating the amount it is borrowing (the principal), the date it will return your money (maturity date), and the interest rate (coupon) it will pay you on the borrowed money. The interest rate is the profit the investor will make for lending the money.

Before it is issued, every bond is rated by Standard & Poor's or Moody's, the major rating agencies that are tasked with determining the financial ability of the issuer to repay the debt it is taking on. The ratings range from AAA (the best) to D (the company is in default).

The two agencies have slightly different labeling conventions. AAA from Standard & Poor's, for example, is Aaa from Moody's.

Broadly speaking, all bonds can be placed in one of two categories:

• Investment-grade bonds are issued by low-risk to medium-risk lenders. A bond rating on investment-grade debt can range from AAA to BBB. These highly-rated bonds pay relatively low interest because their issuers don't have to pay more. Investors looking for an absolutely sound place to put their money will buy them.
• Junk bonds are riskier. They will be rated BB or lower by Standard & Poor's and Ba or lower by Moody's. These lower-rated bonds pay a higher yield to investors. Their buyers are getting a bigger reward for taking a greater risk.

Junk Bonds and Investment-Grade Bonds

Think of a bond rating as the report card for a company's credit rating. Blue-chip firms with solid financials and steady income will get a high rating for their bonds. Riskier companies and government bodies with rocky financial histories will get a lower rating.

The chart below shows the bond-rating scales from the two major rating agencies.

Historically, average yields on junk bonds have been 4% to 6% above those for comparable U.S. Treasuries. U.S. bonds are generally considered the standard for investment-grade bonds because the nation has never defaulted on a debt.

Bond investors break down junk bonds into two broad categories:

• Fallen angels are bonds that were once rated investment grade but have since been reduced to junk-bond status because concerns have emerged about the financial health of the issuers.
• Rising stars are the opposite. The companies that issue these bonds are showing financial improvement. Their bonds are still junk, but they've been upgraded to a higher level of junk and, if all goes well, they could be on their way to investment quality.

Who Buys Junk Bonds?

The obvious caveat is that junk bonds are a high-risk investment. There's a risk that the issuer will file for bankruptcy and you'll never get your money back.

There is a market for junk bonds, but it is overwhelmingly dominated by institutional investors who can hire analysts with knowledge of specialized credit.

This does not mean that junk-bond investing is strictly for the wealthy.

The High-Yield Bond Fund

For individual investors who are interested in junk bonds, investing in a high-yield bond fund can make sense.

You're dabbling in a higher-risk investment, but you're relying on the skills of professional money managers to make the picks.

High-yield bond funds also lower the overall risk to the investor by diversifying their portfolios across asset types. The Vanguard High-Yield Corporate Fund Investor Shares (VWEHX), for example, keeps 4.5% of its money in U.S. bonds and 3% in cash while spreading the rest among bonds rated from Baa3 to C. The Fidelity Capital and Income Fund (FAGIX) keeps nearly 20% of its money in stocks.

One important note: You need to know how long you can commit your cash before you decide to buy a junk bond fund. Many do not allow investors to cash out for at least one or two years.

Also, there is a point at which the rewards of junk bonds don't justify the risks. You can determine this by looking at the yield spread between junk bonds and U.S. Treasuries. The yield on junk is historically 4% to 6% above U.S. Treasuries. If you see the yield spread shrinking below 4%, it's probably not worth the added risk. to invest in junk bonds.

One more thing to look for is the default rate on junk bonds. This can be tracked on Moody's website.

One final warning: Junk bonds follow boom and bust cycles, just like stocks. In the early 1990s, many bond funds earned upwards of 30% annual returns. A flood of defaults can cause these funds to produce stunning negative returns.