It's fairly likely that most people have heard the term junk bond; it's also just as likely that the term is somewhat misunderstood. Junk bonds are not a special type of bond. They are, in fact, regular high-risk, low-rated corporate bonds. Junk bonds have Standard & Poor's ratings of BB or less, which includes debt instruments of poor quality that may be close to default. Some junk bonds have no ratings whatsoever.

In order to entice investors to buy, issuers of junk bonds must set their coupon rates (or, the bond's stated interest rate) higher than those of investment-grade bonds (S&P-rated BBB or higher). A major reason for this is that junk bond issuers are often young growth companies with weak balance sheets or financially troubled organizations that may have no capital-generating alternatives left other than to issue junk bonds.

However, junk bonds have also been used by numerous corporations to finance their takeovers of other companies. This factor accounted for the major growth in the junk bond market during the 1980s, when issues were marketed and sold directly to the public. By creating a ready network of potential investors, companies established a low-cost cash-generating alternative to the traditional source of borrowing funds from banks. Unfortunately, with the economic slowdown in the latter part of that decade, the junk bond market was overwhelmed with an ever-increasing number of defaults. This resulted in the collapse of the market, with institutional investors, mutual funds, and even many small investors pulling their money out. Consequently, the bottom fell out of junk bond prices, and those investors who were left holding them found that they couldn't sell them and as a result lost much of their investment capital.

For investors who bought and sold junk bonds at the right time, the gains were large. Nevertheless, the risks are very high, which necessitates that the yields also be very attractive. In addition to the fact that junk bonds have greater price swings than more highly rated issues, investors must also contend with the ever-present possibility of default. And junk bonds do indeed default.

Generally speaking, junk bonds can be expected to do well in a strong economy, because there's less risk of the company's default. During periods of economic weakness, however, the risk of default rises. For the junk bond investor, broad diversification of junk bond issues can lessen this risk.

Over the years, the junk bond market has gained a reputation that hasn't exactly boosted its credibility. Because junk bond trading is unregulated and investors often don't have access to accurate price information, dealer quotes can vary significantly. Individual investors can therefore find themselves at a distinct disadvantage if they need to buy or sell quickly. Due to the risks involved, wise investors usually limit investment in junk bonds to a relatively small percentage of their total investment portfolio.

Investing in junk bonds is generally not for the unsophisticated. It's much better suited for those who are experienced and capable enough to analyze the financial statements of issuing companies in order to differentiate the potentially better high-yield bonds from those that are likely destined for bankruptcy.

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