Investing for Beginners
with Joshua Kennon

The Sexiest Investment

A Short & Simple Lesson in the Allure [and Danger] of Junk Bonds

You know you shouldn't.  Your CPA wouldn't approve.  Your wife would be furious if she found out.  The guilt would consume you.  Still... you can't help casting a lustful glance at Junk Bonds with their 10-12% rate of return.  Just remember... flashy investments usually go up in smoke, and when these babies fall, they fall hard.  They're called "junk" for a reason.

Lately, I've received a lot of emails about junk bonds and how [if] to invest in them.  Here's a short and to-the-point lesson in what they are and whether you should add them to your portfolio.

The Fundamentals

Every bond in the world falls into one of two categories... investment and non-investment grade.  There is a huge of difference between the two.  Investment grade usually have a rating of BBB or higher.  It is a safe bet to assume that they posses solid fundamentals, a stable balance sheet, and are not in serious risk of default or bankruptcy.  Most have a long track record of making steady interest payments to their bondholders. 

Non-Investment grade have a rating of BB or lower.  They are given such a dismal rating because the threat of bankruptcy or default is large.  The term "junk bond" is simply another way of referring to a non-investment grade bond.  People who invest in them do so with the understanding that it is very probable they will lose all of their money.  In order to get investors to overlook the [very real] chance of this, companies offer outrageously high interest rates.  The problem is... the company had no money to begin with so they can't afford these high rates.

Junk bonds were tremendously popular in the generation of leveraged buyouts and corporate liquidations [otherwise known as the 1980's].  Lately, they have staged a slight comeback with a potentially disastrous outcome.  Small investors are buying them without fully understanding the risks they carry [and once they do figure it out, it will already be too late].

Terminology

A "Fallen Angel" is a bond that was considered investment grade when it was issued, but has since fallen in quality and rating. 

 

The bottom line: Avoid them like the plague unless you know what you are doing!!!

Copyright © 2001 Joshua Kennon
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