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How Junk Bonds Work


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.)

Looking Beyond the Ratings
You 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].

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.

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.