With great risk comes the potential for great rewards.
That's the theory behind investing in junk bonds.
Junk bonds, also called high-yield and below-investment-grade securities, are among the riskiest investments in the credit market. But because of that risk, bond issuers must pay higher yields to attract investors. Traditionally the difference between junk bond yields and the yield on U.S. Treasuries is 4% to 6%.
Ratings and definition
A junk bond, by definition, has a low rating from the credit-rating agencies on Wall Street such as Moody's and Standard & Poor's. S&P, for example, classifies any debt obligation with a rating of BB or less as below-investment grade. For Moody's, anything with less than a Ba rating is dubbed junk.The ratings measure default risk -- the likelihood that a bond issuer will develop financial problems so severe that it will be unable to meet its bond obligations. (The junkiest of the junk bonds -- rated D by S&P -- are already in default.)
Other than those ratings -- and the higher yields that issuers with poor ratings must pay -- junk bonds are just like any other bond. Corporations sell junk bonds. So do cities and states in the muni bond market. Federal debt obligations are seen as exceedingly safe, so there are no U.S. government junk bonds.
The "Me" Decade and the History of Junk Bonds
Junk bonds have been around for quite sometime. By tradition, a bond "became" junk when an issuer ran into trouble and the bond's rating was cut.
But all that changed in the 1980s with the rise of the leveraged buyout in the 1980s.
Michael Milken, an executive at Drexel Burnham Lambert Inc., created the idea of selling high-yield securities to raise money to take over a company. The technique, which earned Milken the title "junk bond king," opened a new source of capital to corporate raiders. It also introduced a new type of investor to Wall Street -- the junk bond speculator.
Junk-bond LBOs worked well when a company's new owners were able to generate enough savings (often through layoffs), raise enough cash (often by selling off pieces of the company) and increase revenue (through better management) to make the payments on the bonds. But when those moves fail, or when the economy heads downward, the risk of default on junk bonds rises.