If you’ve ever yearned for the good ol’ high coupon bond days, you’re not alone. Investors in search of maximum income on their investments may include junk bonds as a part of their fixed income portfolio. High risk vs. high reward junk bonds are issued by corporates or governments can entice investors with higher than investment grade bond yields. Like other bonds, junk bonds have a coupon rate and a maturity date.
However, buying junk bonds means you’re willing to assume higher risks. It’s possible to lose 100 percent of invested capital and the interest payments you hoped to earn if you buy the wrong junk bonds. Evaluate each junk bond issuer you’re considering with great care. It’s possible than any bond issuer can default on principal and interest payments but the chances of default increase with junk bonds.
Risks and Rewards of Junk Bonds
If you’re able to assume greater risk in buying and selling junk bonds, it’s possible to magnify your results. Junk bond selection, along with the use of additional leverage with bonds, can increase your return on these assets. For many investors, investing in high yield bond funds or high yield/junk bond ETF can also add to your fixed income portfolio return without an excessive additional investment of time and energy.
If owning a junk bond high yield bond ETF or index interests you, consider iShares iBoxx $ High Yield Corporate Bond ETF (about USD 14 billion AUM) or consider an index like the S&P U.S. Issued High Yield Corporate Bond Index or B of A/Merrill U.S. High Yield Index.
Junk Bond Issuers
Junk bonds, as the name implies, are riskier bonds. Their sub-investment grade ratings from Standard & Poor’s, Moody’s, and Fitch Ratings reflect less than perfect credit. Because lenders to junk bond issues assume more risk, rates are higher.
There are two basic categories of junk bonds:
Fallen angels were once investment grade issues but became junk bonds. Perhaps the issuer encountered weak sales, earnings, or an event outside of the issuer’s control occurred.
Rising stars are issuers with rising credit. They’re on a path to investment quality credit, but they could fail along the way.
Deciding whether the issuer can make bond interest payments or return principal on time is a “yes” or “no” answer. The issuer’s positive track record of making timely interest and principal payments over years can evaporate with a significant downturn or event.
Start your evaluation of junk bond issuers with credit ratings from the major evaluators. These ratings aren’t guarantees. Perform your own research and seek out broker-dealer coverage of junk bonds you’re considering before making an investment.
Junk Bond Credit Ratings
The three major credit rating agencies, Standard & Poor’s, Moody’s, and Fitch classify bonds from AAA (the highest) to C (Moody’s) or D (S&P, Fitch). Investment grade bonds range from AAA to BBB/Baa credit ratings.
If you’re considering junk bonds, it’s important to know that you’re taking a leap of faith that most banks can’t (and don’t) make in their own portfolios. If bankers own a bond issue and the issuer encounters financial difficulty, they may offer insurance or letters of credit to help support the business.
Junk bonds have lower than investment quality credit for a reason. Owning unpredictable junk bonds can add to your stress level: you must monitor these investments because it’s possible for these bonds to crash before a new financial calamity is announced. Some junk bonds aren’t actively traded and spreads can be wide if you need to sell.
If you’re interested in earning higher returns in junk bonds and you want to pick junk bond issues, spread your risks. Dedicate a small percentage of your fixed income portfolio and don’t buy too much of any one issue. It’s wise to avoid junk bonds in a retirement plan, such as an IRA or individually-directed 401k. If you lose money in the retirement account, you can’t write off the loss.
Junk Bonds and Your Portfolio
If you’re a fixed income investor in search of more consistent income payments, know that junk bonds have an increased vulnerability to default. High risk vs. high reward junk bonds can be much riskier to trade when people are uncertain about the economy. If you buy a junk bond in a rising market and the industry group of the issuer or the broad market sells off, your junk bond will sell off. Conversely, an increase in junk bond defaults can signal trouble for the broad high-yield credit market.
Junk bonds are appropriate for investors who can assume risk. If you’re many years from retirement and can afford to lose money dedicated to junk bonds, speak with your financial advisor first. Some financial experts say that only speculators with the highest ability to sustain risk should acquire them.