Advantages, Disadvantages and What They Tell You About the Economy

Junk bonds are corporate bonds that are high-risk and high-return. They have been rated as not investment grade  by Standard & Poor’s or Moody’s because the company that issues them is not fiscally sound. Therefore, they tend to have the highest return, compared to other bonds, to compensate for the additional risk. This is why they are also known as high yield bonds.

Ratings

Junk bonds are rated by Moody’s and Standard & Poor’s as being speculative. This means the company’s ability to avoid default is outweighed by either uncertainties, or its exposure to adverse business or economic conditions. A rating of Ba or BB is less speculative than a C rating. Most junk bonds are rated B. Here’s the specifics:

• High Risk — Rated Ba or B by Moody’s, and BB or B by Standard & Poor’s. The company currently is able to meet payments, but probably won’t if economic or business conditions worsen. That’s because it’s unusually vulnerable to adverse conditions.
• Highest Risk — Rated Caa, Ca or C by Moody’s, and CCC, CC or C by Standard & Poor’s. Business and economic conditions must be favorable in order for the company to avoid default.
• In Default — Rated C by Moody’s and D by Standard & Poor’s. These are currently in default.

Junk bonds are often categorized as either Fallen Angels or Rising Stars. As the names imply, the former are bonds that were investment grade initially, but were lowered because the company’s credit became worse. The latter are junk bonds whose ratings were raised because the company’s credit improved. They may eventually become investment grade bonds.

To compensate for the higher risk of default, junk bond yields are usually 4-6 points higher than those on comparable U.S. Treasuries, which are backed by the federal government. Junk bonds make up the debt of 95% of U.S. companies with revenues over $35 million, and 100% of the debt of companies with revenues lower than that. For example, familiar companies like U.S. Steel, Delta, and Dole Foods issue junk bonds. (Sources: NASDAQ, Everything You Need to Know About Junk Bonds ; Creighton EDU An Explanation of Junk Bond Ratings )

Advantages

Junk bonds can boost overall returns in your portfolio while avoiding the higher volatility of stocks. First, they offer higher yields than investment-grade bonds. Second, they have the opportunity to do even better if they are upgraded, or the business does well. Because of this, junk bonds are not highly correlated to other bonds.

Junk bonds are more highly correlated to stocks, but are less volatile because they also provide fixed interest payments. Last but not least, bondholders get paid before stockholders in case of bankruptcy.

Another advantage is that they are usually issued with 10-year terms (or less), and can be called after four to five years. Junk bonds perform best in the expansion phase of the business cycle. That’s because the underlying companies are less likely to default when times are good, which reduces the risk. (Source: PIMCO, Investment Basics )

Disadvantages

If the company defaults, you’ll lose 100% of your initial investment. That means you need to analyze the credit risk of each company. If you invest in high-yield mutual funds instead, hopefully the manager does that before purchasing any bonds.

Even if that’s the case, credit-worthy companies can get caught by large-scale trends. In 2014, oil prices plummeted, catching many U.S. shale oil drillers off-guard. Energy companies comprised 16% to 20% of the high-yield bond market. It would be a disaster if that many companies default in 2015.

History

In the 1780s, the new U.S. government had to issue junk bonds because the risk of default was so high. In the early 1900s, junk bonds returned to finance the start-ups of companies that are well-known today: GM, IBM, and J. P. Morgan’s U.S. Steel. However, after that all bonds were investment grade until the 1970s, except for those that had become “fallen angels.” Any company that was speculative had to get loans from banks or private investors.

In 1977, Bear Stearns underwrote the first new junk bond in decades. Drexel Burnham then sold seven more junk bonds. In just six years, junk bonds more than a third of all corporate bonds.

Why? The main reason was research published by W. Braddock Hickman, Thomas R. Atkinson, Orin K. Burrell, that showed junk bonds offered much more return than was necessary for the risk. Drexel Burnam’s Michael Milken used this research to build a huge junk bond market, which grew from $10 billion in 1979 to $189 billion in 1989. During this decade of economic affluence, junk bond yields averaged 14.5% while default were just 2.2%. However, Millken and Drexel Burnham were brought down by Rudolph Giuliani and financial competitors that had previously dominated corporate credit markets against the high-yield market resulted in a temporary market collapse and the bankruptcy of Drexel Burnham. Almost overnight, the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year. The junk bond market didn’t return until 1991. (Source: Glenn Yago, Library of Economics and Liberty, Junk Bonds

What Junk Bonds Tell You about the Economy

Junk bonds can give you an early indication of how much risk investors are willing to take on. If investors get out of junk bonds, that means they are becoming more risk averse, and don’t feel optimistic about the economy. This could predict a market correction, a bear market or (worse of all) a contraction in the business cycle. On the other hand, if junk bonds are being bought, it could mean that investors are becoming more confident about the economy, and are willing to take on more risk. That could forecast a market upturn, a bull market or economic expansion. (Source: The Reformed Broker, What Are Junk Bonds Trying to Tell Us. August 21, 2013)

For example, junk bond purchases took off in the summer of 2013 in response to the Fed’s announcement it would begin tapering Quantitative Easing. This meant it would buy fewer Treasury notes, a signal that it was lessening its expansive monetary policy and that the economy was getting better. As a result, interest rates on Treasuries and investment-grade bonds rose, as investors started selling their holdings before everyone else did.

Where did the money go? A lot went to junk bonds because investors saw the return was worth the risk. Since the economy was getting better, it meant the companies were less likely to default. Demand was so high that banks started packaging these junk bonds and reselling them as collateralized debt obligations. These are derivatives backed by the bundle of loans. They helped worsen the 2008 financial crisis, because the companies defaulted on the loans when the economy started to falter. As a result, few banks sold them until 2013. That’s when demand for junk bonds increased, and banks needed the extra capital to meet financial capital requirements. (Source: Housing Wired, Junk Bonds the Penicillin for Fed Tapering. August 19, 2013)

How to Buy Junk Bonds

You can purchase junk bonds either individually or through a high yield fund through your financial adviser. Funds are the best way to go for the individual investor, because they are run by managers with the specialized knowledge needed to pick the right bonds. Keep in mind that many funds forbid you from withdrawing your investment for the first year or two. (Source: Investing in Bonds.com )

Another way to invest is through junk bond exchange traded funds (ETFs). The two biggest are HYG and JNK. Article updated January 31, 2016.

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