Posted on 30 August 2013.
Because of their name, “junk bonds” usually catch a bad name and are associated with investment scams or are considered being a waste of time. On the contrary, junk bonds can definitely assist you in diversifying your portfolio with high yield returns. To understand the junk bond market, you must first learn the basics, and what to look out for.
From all technical standpoints, a junk bond is just like a regular bond. Basically, a junk bond is simply an “I Owe You” from a company or organization that agrees to pay you back a certain amount by a certain date with an agreed interest rate that they will pay on the borrowed capital. Breaking down the above statement, here are common terms to be associated with the junk bond market.
Principal: The base amount you are requesting to borrow
Maturity Date: The date that agreed to pay the capital back.
Coupon:The interest rate associated with the borrowed capital
Junk bonds get that label due to the credit quality of their issuers. This is a characterization all bonds are subject to, and they usually fall into one of two different categories.
Investment Grade: Bonds that are issued by low to medium risk lenders. The bond rating on investment grade debt ranges from AAA to BBB. While they may not offer large returns, the risk of the borrower failing to pay the interest payments (or defaulting) is much smaller.
Junk Bonds: Offers high yields to the bondholders because borrowers have no other option. Their credit ratings are not usually appealing which makes it difficult for them to acquire the money they need at an inexpensive cost. Junk bonds usually fall into ratings “BB/Ba” or less.
A bond rating is basically like a scorecard offering the company’s credit ratings. Firms that offer safer investments have high ratings of course while companies with high risk receive low ratings.
While junk bonds pay higher yields there is also a high risk that the company in question will default on the bond. There are two categories that junk bonds themselves can be broken down into:
Fallen Angels: The bond originally started out as an investment grade but was reduced to junk bond classification because of the issuing company’s poor credit.
Rising Stars: Logically, it’s the exact opposite of “Fallen Angels” junk bonds. The issuing company’s credit continues to improve which will in the end, rise to investment quality.
Before starting to buy all the junk bonds you can possibly find or telling your broker to go on a full search, you need to understand the risk involved. For those of you who dabble in investments and do not have a large amount of capital behind you, junk bonds can be a dangerous venture. When investing in the junk bond market you need to accept the fact that there is a possibility of never seeing your capital again. Additionally you need to make sure you have some advanced analytical skills (or your broker does), especially in specialized credit. Those who have a large amount of money to invest with or are motivated to risk all for high yield returns are usually key junk bond players. Usually, the junk bond market is the playground for institutional investors.
Although the junk bond market can be a risky investment area, individual investors using high yield bond funds does make sense. You are diversifying your investments across the board while also taking advantage of the professionals whose job is to basically spend their days researching junk bonds. Before diving in, you need to make sure you have an idea on how long you can commit your cash to a junk bond. There are certain junk bonds that won’t allow you to cash out for a few years. You need to also make sure the rewards justify the amount of risk you are taking. Historically, junk bonds only have a high yield between 4-6% above treasuries. If that yield has fallen below 4% your timing is off and you should avoid the junk bond market. Be sure to always look for the default rate on the particular junk bonds as well. You can use Moody’s website for assistance.
For those of you that will inevitably journey into the junk bond market, there are ways to receive high yield returns without a large amount of risk. How? Here’s our secret:
There are a number of mutual funds and ETFs (Exchange Traded Funds) that invest in the junk bond market and offer attractive dividends that are based on the high yielding junk bonds they hold. By investing in the junk bond market through mutual funds or ETFs (as they invest in numerous junk bonds), you greatly reduce the risk of losing your investment principal. Also, junk bond mutual funds and ETFs are managed by professional money managers that seek out the best junk bonds to invest in and are capable of foreseeing default problems and selling bonds that are in danger of default. Finally, junk bond mutual funds and ETFs offer liquid trading markets that make it easy for investors to buy and sell them, whereas individual junk bonds may be thinly traded and difficult to efficiently buy and sell.
So there you have it. While there is an high amount of risk in the junk bond market, there is a potential to receive high yields. Our bottom line advice? Forget about investing in individual junk bonds, reduce the amount of risk you are taking by going through the mutual funds and ETFs that are investing in a large group of junk bonds. This way you keep your capital investment principal a little safer than what it would be as you trade individual junk bonds. It’s a great way to diversify your investments, as long as you know what you are doing and what you are getting yourself into. As with any investment, make sure the rewards are worth the risk.
Happy trading, let us know how you fair!
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