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Investments

2003-05-01 12:39:00

What is a junk bond?

:  What is a "junk bond"?

ANSWER:  Think of a bond as an "IOU".  A bond is a loan.  A corporation, an organization, or a government can issue (or sell) bonds.  When this happens, the corporation, organization, or government is borrowing money from somebody.     If you buy the bond, the money is owed to you.     Would you rather have a bond that pays 6% or 12%?  The best answer is "It depends."  It depends on who issued the bond and how much risk you are willing to assume.  There would probably be a much greater likelihood of default with the 12% bond.     You have probably heard of Moody's and Standard & Poor's.  Among other things, they evaluate the quality of bonds.  If the bonds are considered low to medium risk, they are considered "investment grade".  If the bonds are regarded as higher risk they are considered "speculative grade" or "junk bonds".  With Standard & Poor's, BBB or better is considered "investment grade" and BB or worse is considered "junk".   With Moody's, Baa is considered "investment grade" and Ba or worse is considered "junk".     Are "junk bonds" really junk?  Once again, it depends.  Some "junk bonds" are wonderful investments and some "junk bonds" turn out to be worthless.  They are called "junk" because there is more risk.  That risk may reward investors with higher returns, or it may result in losses for investors.     "Junk bonds" can be further categorized as "fallen angels" or "rising stars".  "Fallen angels" refer to bonds that had once been investment grade.  Because of a decline in the credit worthiness of the bond issuing company, the bonds deteriorated to "junk" status.  Let me provide a personal illustration.  Pan American World Airways was once a fine airline.  In 1990 their bonds were considered "junk bonds".  For $385 each, I purchased bonds with a coupon of 13.5% (yield of 35% on my investment).  At maturity Pan Am was obligated to pay $1,000 for each $385 I invested.  While I knew the bonds were very high risk, I hoped I would get a few interest payments, even if I never got the $1,000 at maturity.  But these "fallen angels" were truly "junk" and my investment was a total loss.     "Rising stars" refer to bonds of companies that may be growing or improving in credit worthiness, but are not yet "investment grade".  I will use another personal example.  Before MCI became a tremendous success story (and long before it's ultimate fall), in 1983 I purchased MCI bonds with a coupon of 14 1/8%.  I paid $983 per bond and received the interest and later sold the bonds for $1,000.  While the Pan Am bond purchase was a loss, the MCI bond purchase was a success.  So some "junk bonds" are better than other "junk bonds".In the last year the Merrill Lynch "High-yield corporates" index reached almost 14%.  Recently it has been as low as 10.14%.  Bond prices go up as bond yields go down.  In the first quarter of 2003 "junk bond" funds have outperformed most asset classes with a return of approximately 5.6%.   About $10.5 billion went into "junk bond" funds in the first quarter of this year.  With 10 year treasuries yielding less than 4% and 30 year treasuries yielding less than 5%, the attractiveness of "junk bonds" is easy to understand.     Professional advice and/or management is highly recommended with junk bonds.  There can be liquidity issues as well as credit issues.  In other words, it might be easier to buy the bonds than to sell them.  Suitability is another important consideration.  Even if a "junk bond" looks attractive, it has to be right for your circumstances and goals for it to be appropriate for you.