Investors are frustrated with the stock market. Year-to-date, the S&P 500 Index is barely positive…and…significantly down from a decade ago. That lack of performance has motivated investors to search high and low for better yields.
For better or worse, junk bonds are increasingly drawing the attention of yield-starved investors! Let’s take a closer look at junk bonds by defining what they are, exploring their appeal, examining attendant risks, and their suitability.
What exactly is a junk bond? Also known as “high-yield” bonds, junk bonds are bonds (debt) issued by corporations that carry a very low credit rating from agencies like Standard & Poor’s and Moody’s. These corporations have weak financial characteristics.
What is their appeal? In a word, the answer is “yield.” Junk bonds typically offer yields that are much higher than available through United States Treasury Securities or high-quality corporate bonds…sometimes double! Recently, some junk bonds have been yielding in excess of eight percent.
What are the primary risks? The two primary risks are 1) default and 2) sharp swings in bond values. Because junk bonds are issued by financially weak corporations, there is above-average risk of default on paying interest and/or principal. Investors need to consider return of investment in addition to return on investment. In addition, the values of these bonds are highly susceptible to large swings, making them more like stocks than bonds. That is because their values are closely tied to corporations that may have difficulty servicing their debt. For example, junk bond values declined, on average, more than thirty percent in 2008…as did the S&P 500 Index.
Are they suitable investments? That depends on several different factors including, but not limited to, an investor’s net worth, his or her ability to tolerate loss of interest payments and/or return of principal, the investor’s understanding of the true risk, time horizon, and need for income. Hint: A mutual fund investing in a broad range of junk bonds can minimize the risk of default compared to an individual bond.
For some people, junk bonds can play a valuable role; however, that role needs to be limited, carefully weighed, and prudently structured. Junk bonds are called “junk” for a reason, and they are highly speculative in nature. Words like caution, diversification, care, and moderation come to mind.