JUNK

JUNK

As you well know, when you buy a bond you are lending the issuer money, money that they promise to pay back at a specified time in the future. They also promise to pay a coupon, or interest rate, usually twice a year.

An issuer’s bonds are rated, based upon the ability to meet its obligations. A company with a high probability of meeting its debt obligations might may have a rating as high as AA or AAA, while a company with low probability will garner a BB or lower and be labeled as junk.

The interest rate given to investors reflects the risk of an issuer defaulting on payments and possibly failing to repay investors upon maturity. That is called credit risk. The coupon payment reflects the rate the issuer has to offer to attract investors. An investment grade bond will have a rating of BBB or better, while a high yield, or junk bond, may have a rating as low as D.

Issuers of junk bonds are now lining up in the streets to issue debt due in part to low rates and Standard and Poors revisal of its estimates of bond defaults. The average junk bond rates are now at 9.9% down from 19.5 % at the beginning of the year. Previously the rating agency forecast defaults at 13.9% but they just cut that number down to 6.9% Investors are coming in in droves to purchase the debt due to the lowered default risk, and still a pretty good interest rate. Junk bonds have rallied continuously since March and are showing 51% returns; not bad for a bond. Junk issuers are still feeling the effects of a record smashing influx of new money into the bonds; to the tune of $27.8 billion.

One thing to remember, a lot of issuers are merely postponing defaulting by issuing new debt to pay for outstanding debt, as well taking advantage of President Obama’s pouring aid into the credit markets.

If the low default rate of 6.9% still seems too risky despite the relatively good yield, investors can purchase shares of high yield bond funds. Keep in mind that expenses will take a bite out of your returns and know when your fund makes its capital gains distribution so you are not buying in right before the fund drops. Not only will you lose money, you will have tax consequences.

Good luck and happy investing.