Junk Bonds – A Much Better Investment Than It Really Sounds Like.

Junk bonds (also known as high-yield bonds) acquired the name as a consequence of their low rating by the major agencies and their high rate of default. What is default? It's just the failure to repay principal or suspension of interest payments. And in the 1980s, a man named Michael Milken discovered that the default rate was unlikely to be as high on certain bond issues than was previously thought. And so, high-yield bonds were born.

Of course, high yield bonds existed long before. But it was Milken who developed techniques for predicting with greater confidence which were and were not truly 'junk'. And, Milken's group encouraged the issuance of those bonds then profited from them - illegitimately so, some argued, which led to later legal entanglements. The result has been: millions made millions by taking calculated risks on high-yield bonds.

That's the key to prudent investing in junk bonds: Calculated risks. As any investor knows, throwing darts blindfolded works less well in the bond market than in the stock market where it already works badly. Fortunately for those with the time and temperament to make the effort, research on bonds is available by the carload.

Step one is to get a rating from one of the major agencies, such as Standard & Poor's, Moody's or other. Junk bonds are distinguished from 'investment grade' (AAA/Aaa, AA/Aa, A/A, BBB/Baa) and carries a designation of BB or below.

But there are many steps after step one, including carrying out independent research on a company's current financial status and likely prospects, just as one would when buying stock. All the usual potential concerns exist: changes in prevailing interest rates, recession or high unemployment and whether there are technological changes causing a company's product or service to be obsolete.

Carrying out that research takes practice and guidance, but that too is available in abundance via simple Internet search. The diligent will quickly find advisors with a good track record, who make objective, moderately cautious statements about a potential buy.

And there are success (and failure) stories to learn from. For example: In 1991, those who risked investing in lower rated bonds reaped the highest total returns: an average 34.5%. One year later, in a less outstanding year for bonds, junk debt took second place in the race for high returns, 18.2% compared to 22.4% return on convertible debt. 'Convertible debt' has more than one definition, but one example is the purchase of bonds which can be converted to common stock at the holder's option.

The example remains relevant today. In some categories, high-yield bonds constitute almost a third of the total issues. And, even at the lower figure, the returns challenge the average return on shares. Of course, nothing can beat those high flying stocks that some are lucky or skilled enough to pick.

What constitutes a high yield is relative to general rates of return, of course. But historically, anything above 8% or so would be considered very healthy and 15% exceptional. By comparison, the S&P 500 has an average return of about 12%, if the investor stays in for several years or even decades.

As with any high risk investment, the total portion in a portfolio shouldn't be more than 10-20% depending on the research backing the choice and an individual's tolerance for risk and potential loss of capital.

Junk Bonds