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Browse the article How Junk Bonds Work

How Junk Bonds Work

by Jane McGrath

Introduction to How Junk Bonds Work

You finally stashed away some extra savings. Rather than pouring your precious funds into some slick technology, you decide to play the market. That's when you learn that there's more to investing than buying a few shares of Google and retiring early. Stocks, bonds, mutual funds -- there's a whole raft of different securities to sink your money into, and perhaps the most dubiously named of them all is the junk bond.

bond with maturity date, principal, interest

You might need to know these terms if you buy junk bonds.

To understand junk bonds, let's clarify what bonds are and how they differ from stock. Whereas stocks represent partial ownership of a company, bonds are simply loans. When you purchase a bond, you're agreeing to lend money to the bond issuer, such as a company or a government. The issuer in turn is promising to pay you back the loan with interest by the date of maturity. You receive that interest regularly, often every six months. That fixed payment is why bonds are called fixed-income securities, as opposed to stocks, which carry variable returns.

Junk bonds are bonds issued by companies with low credit ratings, as opposed to the investment-grade bonds offered by corporations with better credit and longer track records. Credit-starved companies offer to pay out high interest rates to investors like you, nice enough to loan them your hard-earned money. Because of their high rates of return, junk bonds are also politely called "high-yield bonds."

So are junk bonds for you? In this article, we'll explore this underdog of the investment world and its turbulent history. We'll also learn why some bonds are dubbed junk and whether you should devote a portion of your financial portfolio to them. On the next page, we'll find out how junk bonds exploded onto the financial scene in the 1980s with Michael Milken, later dubbed the "Junk Bond King."

Quick Glossary to Bond TermsBond: A loan issued by an institution to fund projects and operations. It can be issued by a company, a federal or state government or a municipality (cities and towns).
Date of maturity: The date on which the bond expires and the loan should be paid back in full. Maturity can take 90 days to 30 years.
Default: What happens when the institution that issued the bond cannot fully repay its debt.
Interest rate: The percentage of the amount borrowed that must be paid back in addition to the loan.
Principal amount: The face value of the bond.
[Source: Investopedia]

Michael Milken and the History of Junk Bonds

Junk bonds have survived a dramatic rise and fall in popularity, as well as heated controversy. Before the 1980s, few companies issued junk bonds. The only ones available were from established companies that had fallen on hard times. That changed in the late 1970s when young companies with no credit began issuing bonds that started out as "junk" in order to get off the ground. Junk bonds became a common investment tool by the early 1980s, setting the stage for the ambitious trader Michael Milken, who later became known as the "Junk Bond King."

John Chiasson/Getty Images
Milken in 1988 before he went to prison (and before he was named one of the world's richest people in 2006)

Milken worked for the investment bank Drexel Burnham Lambert, and he recognized the incredible financial opportunities that came with the rise in junk bonds during the heady 1980s. Believing that the rewards outweighed the default probabilities, he advised bond issuers and investors to take full advantage of them, hence setting junk bonds ablaze in popularity and success.

One of Milken's more successful and controversial tactics had to do with using junk bonds to finance hostile takeovers of companies; that is, attempting to buy them against their will. With junk bonds, the acquiring company could borrow serious cash with little or no assets and use it to bid on another unwilling company, or target. Believing that a change in management would make these targets more profitable, the acquiring company would then use the target's newly acquired assets to repay the debt it incurred to fund the takeover.

This technique offended many people's ideas of fair business practices and generated a lot of animosity toward Milken. On top of that, protestors objected to the tax laws that assisted these hostile takeovers. Because the interest payments on debt are tax deductible, companies could more easily fund their takeovers with junk bonds.

The junk bond craze came to a screeching halt by the end of the 1980s. Default rates rose significantly, and suddenly no investors were willing to buy them. Investors have since returned to these volatile securities, keeping a sharp eye on their ratings.

Milken's Success Sours
Milken's successful financial trading career ended on a sour note when he was accused of insider trading and securities fraud. After being arrested and charged with insider trading, Ivan Boesky, one of Milken's clients, implicated him, as well as his employer, Drexel Burnham Lambert. Both Milken and the company were slapped with hefty fines, and Milken was sentenced to 10 years in prison (though he only served two). By 1990, Drexel filed for bankruptcy. Despite a lifetime ban from the securities business, Milken was named No. 382 in Forbes's 2006 list of the World's Richest People [source: Forbes]. Learn more about business fraud in "How Cooking the Books Works."

Even without Milken and Drexel, the junk bond market later recovered, though it still hasn't hit the heights of its heyday.

Making the Grade: Junk Bond Ratings

How do you know whether you have a junk bond on your hands? You check out the rating -- the financial equivalent of a letter grade you get in school -- assigned by a ratings agency. The best known of these agencies include the following companies:

All these services use a report card-type letter system to rate bonds, with an AAA or Aaa being the best grade and a C or D being the worst, depending on which service reported the rating (see the chart below to compare them). Often you will see grades with additional + and - signifiers.

Standard & Poor's	Moody's	Fitch	Grade	Risk
AAA	Aaa	AAA	Investment	Low
AA	Aa	AA	Investment	Low
A	A	A	Investment	Medium
BBB	Baa	BBB	Investment	Medium
BB	Ba	BB	Junk	High
B	B	B	Junk	High
CCC	Caa	CCC	Junk	High
CC	Ca	-	Junk	High
C	-	-	Junk	High
D	C	DDD, DD, D	Junk	Default

It is important that the ratings are accurate and consider all factors to be fair to investors and issuers alike. Stella Kapur, a director at Standard & Poor's, explained in a podcast how her team arrives at their ratings. Among other things, they inspect the company's ability to repay debt. She and her team might ask the following questions:

Does the company have enough money to pay the promised interest rate payments?
How is the company's liquidity (or ease with which it can convert assets into fast money)?
How does the company's cash flow (or amount of money earned and spent, compare to the debt it has accrued)?
How much money does it cost to run the company successfully?
What are its future goals and strategies? How much will they cost to reach?
What industry is the company in? How does it compare to competitors?

Though a company may be ready to pay off its debts, it may not necessarily be willing, Kapur added. The willingness of a company can be assessed from its financial plans.

As you might guess, and Kapur seconded, the rating process cannot be boiled down to a simple formula; it takes practiced judgment to decide which factors should be considered more important than others, depending on the situation.

In addition, ratings are never set in stone. Newspapers constantly report that Standard & Poor's, Moody's or Fitch have downgraded or upgraded a bond rating. When one service makes a change, the others are likely seriously considering it. Standard & Poor's keeps a close eye on corporate news and changes ratings accordingly. In addition, if nothing newsworthy occurs, the service makes sure to review each rating at least once every three months. Listen to the podcast and learn more about the system by visiting Standard & Poor's Web site.

In addition to these ratings services, the U.S. Securities and Exchange Commission (SEC), which oversees the market, occasionally will investigate junk bonds. After Milken and Drexel were charged with securities fraud, the government began to investigate the legitimacy of junk bonds [source: Wallace].

U.S. Government Bonds Belong in Junk Drawer?
Moody's Investors Service made headlines in January 2008 when analysts expressed concern over the creditworthiness of what is historically the most iron-clad of all investments: U.S. government bonds [source: Reuters]. The possible future expenses of Medicare and Social Security have frightened Steven Hess, a Moody analyst, into questioning the high rating of the bonds [source: Reuters]. Economist John Williams even suggested they be downgraded to junk-bond status to compensate for the weakening U.S. dollar [source: Corsi].

Now that we understand how junk bonds get their ratings, we can make better decisions as to whether to get them and how to pick the best ones, which we'll discuss in the next section.

Should you invest in junk bonds?

And now for the million-dollar question: Are junk bonds worth the risk? The answer, according to many investors, is yes -- that is, if you do your homework. If you are ready to be more aggressive with your investments and make the plunge into junk, research is essential.

Morningstar, an investment research company, offers some advice on how to conduct this research. The company's analysts suggest, among other things, that you ask the following questions:

Does the company have sound financial goals and structure?
Do its financial ratios seem promising? This includes comparing its short-term assets (such as cash, inventory and liquid assets) to its short-term debts and comparing its total debt to its total equity.
How does it compare with the competition in the industry?
How successful is the industry as a whole?
What is the bond's date of maturity? (Shorter maturity time is often better: The shorter the duration of the bond, the less chance that it will default.)

You might notice that many of these questions are similar to those that Standard & Poor's asks. But finding these answers out for yourself will give you a better idea of the bond. Individual investors sometimes find this research too difficult. To make it easier, they might invest in junk bond funds assembled by investment banks; however, even then, you still have homework to do.

Looking Beyond the RatingsYou can't always judge smart investments by the company's credit ratings. Another Standard & Poor's director, Saul Samson, suggests that a company can be doing everything right and still fail to receive a good rating. Taking risks can be essential to growing a good business and, in the end, is how a business benefits society. But, it can also mean getting a lower rating. Conversely, getting a high rating could indicate that the company's financial policy is not aggressive enough [source: New York Times].

Although research will make you a better investor, it will not necessarily eliminate the high risk involved in your junk investment. Junk bonds should only make a small part (about 5 percent to 10 percent) of a diversified portfolio, one that includes a mix of various kinds of investments that span several industries [source: Leckey]. Typically, the more you devote to junk bonds, the more aggressive you are.

Like with many investments, timing is everything, and financial experts disagree about the best time to buy junk bonds. More conservative investors only purchase them during economic booms. Others will go further and buy them during a recession at a time when they predict the economy is about to rebound.

Junk bonds are not for the casual investor. A smart purchase requires careful planning and familiarity with market fluctuations. Even then, junk bonds pose a high risk. Visit the links on the next page to help you rifle through the pile and find some valuable junk.

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