Investing in bonds has become more and more popular in recent years. Those that have been scared away from the stock market for one reason or another often turn to bonds as a safer means of investment. One type of bond in particular that has attracted investors is the junk bond. Here are the basics of junk bonds and some things to consider before you invest in them. 

What Is a Junk Bond?

When you invest in a corporate bond, you are essentially lending money to the company that issues it. They then pay you a set rate of interest over a long period of time and eventually give you your investment back. The main risk with a corporate bond is that the company goes bankrupt. However, with bonds, even this risk is minimized because you are a creditor. There is a chance that you will get your money back even upon bankruptcy. 

Each bond that is issued is given a rating by Standard & Poor's and Moody's. The bonds that are issued by the biggest and best companies with good credit histories are given ratings of AAA. The bonds that are issued by companies with terrible credit and debt situations are rated C. Every rating from BB through C is considered a junk bond. Therefore, if you invest in this type of bond, you are taking a higher risk and investing in a company that has a questionable situation. 

Why Invest in Junk Bonds?

With this information, you may be wondering why anyone would want to invest in junk bonds. However, the answer goes back to the old adage of "higher risk means higher potential reward." When you invest in a junk bond, you can get a higher return on your investment. In fact, the interest that these companies pay will often be much higher than the bonds that are rated as AAA. 

The reason that these junk bond issuers pay that much interest is that they have to. They have bad credit scores and may not be able to get a loan from the bank. They also cannot find anyone who wants to buy a bond for a lower rate of interest. Therefore, they have to offer these high interest rate bonds in order to bring in potential investors. 

Investment Considerations

If you are thinking about investing in junk bonds, you will want to look at them as a small part of your portfolio. Junk bond investing is a risky strategy and could come back to hurt you if the company becomes insolvent. Often, companies selling junk bonds will have very high debt loads and not enough assets to satisfy all of the creditors once they file for bankruptcy. This means that your odds of getting your investment back at that point are not that good. While buying a few junk bonds could net you a nice return, you need to combine them with safer bonds as well as other forms of investment. 

blog comments powered by Disqus