Junk Bonds - The Sexiest Investment You Should Avoid In Your Portfolio
A Short and Simple Lesson in the Danger and Allure of Junk Bonds
You know you shouldn't invest in junk bonds. Your CPA wouldn't approve of it and your husband or wife would be furious if you were discovered. The guilt would consume you as you turned down more respectable holdings such as certificates of deposit or investment grade bonds. Still, you can't help but cast a longing glance at that special category of corporate bonds with their much higher-than-average yields. When you do, all I ask is that you remember flashy investments usually go up in smoke, and when these babies fall, they fall hard.
They aren't called junk bonds for nothing. They are, more often than not, exactly that: Junk.
The temptation to acquire junk bonds isn't hard to understand. When I first wrote this article on July 16th, 2001, they were offering 10% to 12% yields. I had been receiving a lot of questions about if, and how, to add them to an investment portfolio. Prior to the most recent, ever-predictable collapse in 2015 and 2016 (following the one experienced back during the 2008-2009 credit crisis), they had been luring investors to their fiscal doom in no small part due to the extended period of near-zero percent interest rates in which savers have found themselves.
Sometimes, people can't accept that inaction is the better way to go. Parking the cash in a bank account and earning nothing on it was a superior strategy than taking on a stupidly priced risk so let me reiterate: There is practically never a good time for the average investor to buy junk bonds. You can, and most likely should, go through your entire life without ever owning one. They are not necessary to build wealth. In fact, they are more likely to cause you to lose what wealth you do have.
Still, if you're interested in what junk bonds are, how they work, and how they differ from a related type of bond referred as "fallen angels", keep reading.
The Fundamentals of Junk Bonds
Bond rating agencies such as Fitch, Standard and Poors, and Moody's assign ratings to debt issues. Every bond in the world falls into one of two categories, investment and non-investment grade.
So-called investment grade bonds have a rating of BBB or higher (some use modification systems; e.g., a BBB- rated junk bond would still be investment grade but rank below a BBB rating, which would rank below a BBB+, etc.). By assigning such a rating, the agency is saying that it believes, based upon 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; the bond coupons flowing like clockwork.
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 of 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 than their investment counterparts. 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.
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. The same story will play out as it seems to do every 10 to 20 years, a new generation learning the painful lessons of their predecessors.
Fallen Angel Bonds versus Junk Bonds
In the course of business history, good companies have sometimes 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 Investing In 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 ample quantitative reasons to believe your purchase promises safety of principal, you are speculating, not investing.
When in doubt, remember the old saying: More money has been lost on Wall Street reaching for a little extra yield than stolen at the barrel end of a gun.