Investing Classroom: High-Yield Or 'Junk' Bonds

Are you a risk-taker? Do you like the thrill of the unknown? If so, junk bonds, also known as high-yield bonds, may be the investment for you. Junk bonds offer higher interest rates because of their lower risk ratings. Some investors feel that the higher interest makes the risk worth taking. As a savvy investor, you should be aware of the risks and rewards of high-yield bonds and how they work as individual bonds and in bond funds.

What are junk bonds?
When you buy a bond, you are lending your money to someone (the government or a private company) who promises to pay you back the money when the bond matures, plus interest. The ability of the bond issuer to meet its obligation is expressed in the bond's credit rating. Whether a company defaults on its bonds or not depends on its ability to pay back its debt.

Bonds that have a high credit rating are known as investment-grade bonds. Bonds that are likely to default are called speculative or non-investment grade. Low-grade bonds may be issued by companies without long track records, or with questionable ability to meet their debt obligations. Because most brokers do not invest in these low-grade bonds, they are known as junk bonds. However, because of the very high interest rates these bond issues typically offer, they are also referred to as high-yield bonds.

Defaults on bonds most often occur within the first several years of a bond's issue. But even when a junk bond defaults, it might still keep some of its value. The impact of a default on a bond's price is known as its default loss rate. Sometimes a bond's actual price loss is not the same as its rate of default loss. A default due to bankruptcy will probably reduce a bond's price more than a default due to a company changing its strategic direction.

Default risk is determined by a credit rating system. A bond's credit rating is based on the risk of a bond issuer not making its payments on time, or at all, and is measured by a grading system that starts with a rating of AAA for bonds least likely to default, all the way down to D for bonds that default. Junk bonds have a rating of BB or lower.

Junk bond creditworthiness
Researching the credit of a company issuing junk bonds is the key to determining whether the bonds are a wise investment. This process is called credit analysis.

A company with strong management and a sound financial strategy can overcome a weak credit rating. Looking at a company's profitability and asset value are good places to begin your research. It is also helpful to see how the rest of the company's industry is doing. Compare the credit statistics of the issuing company with those of other companies in its industry.

Various ratios are also used in credit analysis. One example is the current ratio, the ratio of a company's short-term assets to its short-term debts. The higher the current ratio, the lower the credit risk. Another example is the debt-to-equity ratio, a comparison of a company's total debt to its overall stock value.

Before buying a junk bond, you should also consider its maturity date, the time at which the bond must be repaid by the bond issuer.

Remember that the reason junk bonds offer higher yields is their greater likelihood of default. To avoid losing your money, it is important to have a clear understanding of the creditworthiness of the issuing firm and the factors that will impact its performance.

Market behaviour of junk bonds
High-yield or junk bonds may be actively traded on the bond market. However, their market performance can be quite different from that of higher-grade bond issues. In general, secondary market bond prices move in the opposite direction to interest rates. Of course whether interest rates go up or down depends on many factors, including the Bank of England's (or respective central bank's) monetary policy.

However, junk bonds are less affected by interest rates than are other bonds. This is because they have higher yields and shorter maturities and interest rates are apt to change less over a shorter period. In fact, junk bonds tend to behave more like stocks than other bonds because the strength of junk bonds is connected to the strength of the company that issues them. Therefore, the market behaviour of junk bonds is often more in tune with overall changes in the economy.

In a recession, when interest rates fall, junk bonds might also fall in value because the companies issuing them earn less and are unable to pay off their debts. A rise in company revenues is more important to the health of a junk bond than interest rates are. A strong economy means fewer defaults and more junk bonds that are successful. When the stock market is doing well, companies can replace debt with equity, lessening their chance of bond default and possibly increasing bond prices.

In short, while most bond investors focus on how changes in interest rates will affect the market price of their bonds, high-yield bond investors must also understand the default risk of the issuing firm. They must understand how the company's performance and changing economic conditions impact the risk of default.

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