Junk Bonds: Should You Invest in Them?

Your goal as an investor should be to earn as much money from your portfolio as possible. Often that means loading up on a variety of assets, including stocks and bonds. But while stocks are known to be fairly lucrative, bonds tend to trail behind on the profitability front. Because they're less risky than stocks, bonds typically offer substantially lower returns.

There is, however, an exception to that rule, and it comes in the form of junk bonds. With average yields that are significantly higher than those of more favorably rated municipal or corporate bonds, junk bonds offer generous interest payments compared to the rest of the bond market. The reason, however, stems from the fact that they're not considered investment-grade, and are therefore regarded as the riskiest bonds out there.

What are junk bonds?

For the most part, junk bonds work just like all other bonds. A bond is a debt instrument issued to raise capital. When you buy bonds, what you're effectively doing is agreeing to pay the issuer a certain amount of money up front, known as your principal, in exchange for interest on that sum over a predetermined period of time. Then, once the term of your bond ends, you're entitled to get your principal back.

Corporate bonds and municipal bonds are willing to pay interest to bondholders because it gives those corporations and municipalities access to money they need for varying purposes. In the case of a corporation, it could be to invest in product development, research, or expansion. In the case of municipalities, it could be to improve infrastructure or public schools.

From an investor perspective, investing in bonds is appealing in that it offers a reasonably predictable income stream. When you buy bonds, you can look forward to semiannual interest payments at a predefined rate. Those can then be used to supplement your income, or you can reinvest those interest payments as you see fit.

Where junk bonds differ from other bonds, however, is that they're not rated highly enough to be considered investment grade. (We'll discuss how bonds are rated in detail in just a bit.) As such, when you buy junk bonds, you risk having the issuer default on its bond obligations under your contract. When that happens, you could end up losing out on the interest payments you were promised, or even risk not getting your principal back.

Now, you'll often hear junk bonds referred to as high-yield bonds, and the reason for that boils down to the risk involved. When a company or municipality's finances don't look good, it becomes more difficult for that entity to borrow money. As such, these issuers need to offer a higher rate of return on their bonds in order to lure investors. Therefore, when you buy junk bonds, you're essentially sacrificing peace of mind for what could potentially be a lot more money.

How are bonds rated?

A bond's credit rating will determine whether it falls into the junk category or not. A credit rating is a measure of how likely an issuer is to fulfill its financial obligations. Companies or municipalities on shaky financial ground will, understandably, have lower credit ratings than those in better financial shape.

In fact, you might liken a bond's credit rating to your own credit score. If you have a solid history of paying your bills on time and not borrowing excessively, your credit score will probably be pretty strong. But if you have a number of missed or late payments on your record, and a tendency to open up too many new credit accounts at once, your score will be lower. Once that happens, you might find it more difficult to get approved for things like a mortgage or new credit card. Similarly, companies and municipalities with low credit ratings tend to struggle to secure financing, and so their only choice is often to offer investors a high amount of interest in exchange for taking on the risk of buying their bonds.

There are three well-known ratings agencies that rate bond issuers:

Standard & Poor's (S&P)
Moody's
Fitch

S&P and Fitch use a similar system that rates bond issuers from most stable to least stable as follows:

AAA
AA
A
BBB
BB
B
CCC
CC
C
D (refers to bonds that are already in default)

The Moody's rating system is slightly different:

From there, numbers or symbols are used to further highlight a given issuer's creditworthiness. S&P and Fitch use pluses and minuses for this purpose, while Moody's uses numbers.

For example, an A+ rating from S&P is better than an A or A-, while a Ba1 from Moody's is a higher rating than Ba2 or Ba3. Generally speaking, the lower a bond issuer's credit rating, the higher an interest rate you'll score when you invest in its bonds as a reward for taking on that added risk. Bonds with a rating below BBB- by S&P and Fitch and Baa3 by Moody's are considered junk bonds, or below investment grade.

What information do ratings agencies use to assign ratings? Usually, ratings are based on a number of factors. In the case of a corporation, an agency will look at things like cash flow, growth rate, and existing debt to determine a rating. In the case of a municipality, an agency will look at things like revenue, spending, and outstanding debt.

One thing you should know about bond ratings is that they have the potential to change over time. An issuer might start out with a certain rating, but then pay off some existing debt or report higher profits, at which points its credit rating might increase. On the flip side, an issuer might mismanage its money by overspending, thereby landing itself a downgrade (which means going from a higher credit rating to a lower one).

In fact, one thing you should know about junk bonds is that they often don't start out in junk territory. Often, junk bonds start out as investment grade, but get downgraded over time due to financial problems with the issuers behind them. On the other hand, junk bonds don't always get trapped in sub-investment-grade territory. It's possible for an issuer to start out with a junk rating but have that rating improve over time.

Why do companies issue junk bonds?

If junk bonds are so risky, you may be wondering why issuers bother putting them out there in the first place. After all, is it really worth paying investors such high interest rates?

The answer, often, is yes, and the reason boils down to not having a choice when it comes to securing capital. Often, you'll see emerging or start-up companies issue junk bonds because they need funding and can't get it via traditional loans. As such, these companies might enter the bond market in the hopes that investors will bite if they offer enticing enough yields to make it worth their while.

Most start-ups begin with relatively low credit ratings off the bat because the agencies that evaluate them don't have a long enough track record to vet. It's kind of similar to applying for a loan when you get your first job -- because you don't have much of a credit history, your score automatically gets dinged. But you can't build a solid credit history without...credit.

Such is the plight of many new businesses, and so issuing bonds is the only way to get over that obstacle while securing the funding they need to grow or remain operational. Keep in mind, however, that some of these companies can become successful once they get that funding, so don't immediately write off junk bonds without researching the issuer. If a given company's bonds are considered junk because its management team has historically done a poor job of handling its finances, you may be better off staying away. But if a company has a low credit rating mostly because it's new, yet it looks promising based on its business model or product line, then its bonds may be worth a shot.

Aside from this, remember that many times, junk bonds don't start out as junk bonds. Rather, they start out as investment grade but get downgraded over time. Recognizing the difference between a bond that starts out as junk versus one that becomes junk can help you make a more informed investment decision.

Benefits of buying junk bonds

There are several advantages to adding junk bonds to your portfolio. First, the most obvious: Junk bonds offer higher interest rates than bonds with higher ratings, and so you might snag a higher stream of income by buying them.

Another thing to realize about junk bonds is that their value might rise over time. If positive news about an issuer comes out after you purchase its junk bonds, the value of your bonds might climb, which gives you an opportunity to sell them at a price that's higher than what you paid, thereby profiting that way.

Furthermore, junk bonds tend to perform fairly well during periods of general economic well-being. There are several reasons for this. First, when the stock market does well, individual stocks, or even stock-based mutual funds, can get expensive. Junk bonds can therefore be a competitively priced alternative. Also, when the economy is thriving, even struggling companies might benefit from a general upswing, which makes them less likely to default on their bond obligations.

That said, one thing you should know about junk bonds is that interest rate changes don't usually have the same impact on them that they do on investment-grade bonds. Usually, interest rates have an inverse relationship with bonds so that when rates climb, bond prices fall, and vice versa. But when interest rates rise, it's often a sign that the economy on a whole is expanding, which means there's a higher likelihood that issuers offering junk bonds will manage to meet their obligations, thereby lowering the risk of default.

Furthermore, junk bonds tend to have shorter maturities than investment-grade bonds, which means that you're locking your money away for less time when you buy them. As such, the general interest rate risk that applies to buying bonds factors in less so with junk bonds.

An additional benefit of buying junk bonds relates to predictability. Bond interest is paid semiannually, so barring a default, junk bonds give you an opportunity to secure steady income.

Finally, junk bonds actually take priority over outstanding stock in the event that an issuer files for bankruptcy. This means that if you hold junk bonds, you're going to get paid what you're owed before stockholders are made whole, thereby minimizing your risk of losses in such an event.

Disadvantages of buying junk bonds

While there are plenty of good reasons to add junk bonds to your portfolio, there are several drawbacks as well. First, there's the clear risk that your bond issuer might default on its obligations. When this happens, you risk losing out on interest payments, or, in more extreme cases, your entire principal.

Here's how the latter might play out. Let's say you buy a company's junk bonds, and it's forced to file for bankruptcy and liquidate. Your bonds might then end up only being worth pennies on the dollar, depending on the company's finances. In other words, you might invest $10,000 in junk bonds, only to be told those bonds are worth a mere $2,000 following a bankruptcy event.

Another issue with junk bonds is that if you change your mind about owning them, you might have a harder time selling them than you would with investment-grade bonds. Because junk bonds are so risky, there are fewer investors out there with an appetite for them. So if the need to unload them arises, you might struggle to find a buyer, or wind up forced to sell your bonds at a loss.

Furthermore, if a recession hits, junk bonds can be a particularly unfavorable investment to hold. In fact, investors often turn to investment-grade bonds during periods of economic distress because of their stability; when times are tough all around, the market for junk bonds might be even more narrow than ever. If you own junk bonds and a recession strikes, you might struggle even more to liquidate them, and you also might see their value decline, which means you risk losing money.

Who should buy junk bonds?

It's fairly common for seasoned investors to load up on junk bonds, especially since they're equipped to do the research necessary to choose the right issuers. Similarly, hedge funds and other investment firms have a tendency to buy junk bonds since, again, they have the knowledge and expertise to properly assess the risks involved.

Generally speaking, newbie investors shouldn't buy junk bonds because of the risks that come into play. Rather, beginner investors looking for aggressive growth in their portfolios may be better off loading up on stocks instead, which can produce comparable returns over time.

If you're not an experienced investor but are eager to dabble in junk bonds, your best bet might come in the form of a high-yield bond fund. When you buy shares of a bond fund, you benefit from the expertise of the people who spend their time choosing investments for that fund. Just keep in mind that some high-yield bond funds require you to lock your money away for a preset period of time, so make sure you can afford to do so.

Otherwise, you can buy individual junk bonds through a broker. If you're going to do that, research each issuer thoroughly before you invest, keeping in mind that while an issuer's credit rating will give you good insight about its financial standing, it's not the only factor to keep in mind. Remember, all junk bond issuers, by nature, have poor credit ratings, so what you'll need to do is identify those factors that might set one issuer apart from another. For example, if one junk bond issuer has certain financial prospects going for it (say, a great management team or pipeline of new products, in the case of a corporation), then you should opt for that issuer's bonds over a company whose finances have been declining steadily.

Your decision to buy junk bonds should also take into account your appetite for risk. Risk-averse investors are not well-served purchasing junk bonds because they're by no means considered a stable investment, even with belonging to the bond class. On the other hand, if you have a healthy appetite for risk, then junk bonds might be a solid addition to your portfolio.

When to buy junk bonds

If you're going to buy junk bonds, it pays to invest at a time when their yields are high enough to warrant the added risk involved. To this end, it helps to look at what's known as the yield spread between junk bonds and U.S. Treasury bonds. Treasury bonds are issued by and backed by the full faith and credit of the U.S. government. As such, they're considered virtually risk-free. A yield spread, meanwhile, is the difference between the rate of return on two separate investments. As a very basic example, if Bond A has a yield of 5% and Bond B has a yield of 6%, the spread between them is 1%.

Generally speaking, you want a yield spread of at least 4% between Treasury bonds and junk bonds to justify the risks associated with the latter. If the spread you're looking at is less than 4%, then the time probably isn't right to invest in junk bonds. Instead, you may be better off sticking to more traditional investment-grade bonds if you're intent on adding bonds to your portfolio.

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Maurie Backman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends MCO. The Motley Fool has a disclosure policy.