High yield bonds are also known as “junk bonds” – they are by definition “speculative investments” and should not be purchased by an investor unless that investor is seeking to speculate.
Junk bonds are sold with the promise of higher returns. It’s a buzz-word brokerage firms know how to use to entice people to invest. Let’s face it, who doesn’t want to make higher returns on their investments? And one of the biggest areas of investments providing higher returns is that of Junk Bonds, which is the less-glamorous name for high-yield bonds.
When an investor buys a bond, the investor is lending money to someone (the government or a private company) who promises to pay back the money when the bond matures, plus interest. Whether a company defaults on its bonds or not depends on its ability to pay back its debt. The ability of the bond issuer to meet this obligation is expressed in the bond’s credit rating. Bonds that have high credit ratings are known as investment-grade bonds, while bonds that have low credit ratings are known as non-investment grade or speculative bonds.
Most individual investors believe that owning bonds is good for their portfolio because bonds have historically been viewed as safe investments that provide steady income. Investing in bonds has also been historically viewed as an excellent way of diversifying one’s investment portfolio.
Junk bonds, however, are bonds that are rated as “speculative” or “below investment grade” by the rating agencies (below BBB by Standard & Poor’s and below Baa by Moody’s). Bond ratings measure the perceived risk that the bonds’ issuer will not make interest payments or repay principal at maturity. The riskier the bond is, the lower its rating.
The term junk bonds first came to light in the late 1970s when Bear Stearns and Drexel Burnham jumped into this market with both feet. By 1983, more than a third of all corporate bond issues were rated below investment grade.
Junk bonds have much in common with equities and typically offer equity-like risk premiums. Since junk bonds are perceived to be riskier than other types of debt, they trade at higher yields (or higher rates of return) than do better quality, or investment grade, bonds. Historically, junk bonds have had an average yield of 4-6% higher than comparable U.S. Treasury bonds.
Brokerage firms use the higher yield as a way to sell these types of bonds. Brokerage firms don’t use the term junk bond; instead, the firms use the less-ominous sounding “high-yield bonds.” Often overlooked in the selling of these bonds, no matter what they are called, is that they have a higher risk of default, meaning the investors could lose the money they have invested.
Brokerage firms often fail to inform investors that most junk bonds should be viewed as illiquid investments. The lower the bond’s rating, the more illiquid it is. Most investors think that if they need to raise cash they can go into the open market and sell their bond. With junk bonds, this is often not the case.
Brokerage firms also sometimes neglect to inform investors that although investing in investment grade bonds is an excellent way to diversify one’s portfolio, investing in a junk bond can actually increase the risk in the portfolio. As Larry E. Swedore and Jared Kizer state in their book The Only Guide to Alternative Investments You’ll Ever Need
…fixed-income instruments serve three main roles in a portfolio: a reserve for emergencies, a reliable source of cash flow, and a stable foundation for a portfolio that allows investors to take equity risk.
The risks of high-yield bonds make them inappropriate for consideration for meeting the first two objectives – safety of principal and stability of income. While it is true that high-yield debt has non-perfect correlation with equities, the correlation of the highest-rated bonds with equities is even lower. Thus, investing in high-yield debt isn’t necessary to obtain the diversification benefit. In addition, the correlation of high-yield bonds with equities may increase at just the wrong time – when the risk of equities shows up. In other words, junk bonds don’t mix well with the inherent risks of equities.
The axiom “If it sounds too good to be true, it probably is” certainly applies to junk bonds.
If you have investment losses or problems involving high-yield (junk) bonds, call the lawyers at Page Perry for experienced representation at (404) 567-4400 or (877) 673-0047 (toll free).