Junk Bonds

One way a company can raise money is to get loans from investors; these loans are in the form of bonds. A company will get the money immediately and will then repay the bondholder in regular installments. However, a company’s credit risk must first be rated and given a credit rating before it can issue bonds. Standard and Poor’s and Moody’s are two of the most well-known credit rating agencies; they predict which companies will in all probability make their bond payments on time and which companies will not.

Companies with a higher than average chance of default and inability to make regular payment installments are "speculative grade" or "below investment grade." In other words, they are junk bonds. Junk bonds have a Standard and Poor’s rating of BB and lower, and they have a Moody’s rating of Ba and lower. (To learn more about bond ratings, click here.) Junk bonds have a dismal rating because the threat of bankruptcy or default is large. When economic times are favorable, default rates can be as low as 2 percent. However, when the economy is uncertain, the default rates can go as high as 9 percent. A company with a junk bond rating may also lack a stable balance sheet or may not have a stable track record of making steady interest payments to their bondholders.

People invest in junk bonds for the possibility of high gains. Because junk bonds are riskier, the amount of annual interest which is paid (a coupon) is higher. For instance, a bond that has a AAA rating, and thus a high grade bond, may pay 5 percent per year; but a junk bond could pay as much as 12 percent. Junk bonds are often called high-yield bonds because the yields on junk are higher. Nevertheless, one needs to be cautioned that the risk is much, much higher as well.

Junk bonds were very popular in the 1980s at a time of many leveraged buyouts and corporate liquidations. In the 1980s, Drexel Burnham Lambert, an investment bank, virtually invented the modern junk bond market. The firm's West-Coast chief, Michael Milken, was known as the king of junk bonds and an enabler of corporate raiders. Milken was later charged with securities fraud and Drexel Burnham folded. The outstanding Drexel Burnham high-yield bonds, which had been invested in by Savings & Loan institutions, dropped dramatically and started the S&L crisis during the late 1980s, while tainting the junk-bond name.

Nowadays, junk bonds are considered to be legitimate investments, but debacles still occur and the risk of losing one’s money remains high.