Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

Truth about junk bonds

Dear Dollar Diva,
What is a junk bond?

A junk bond is issued by a corporation or municipality with a bad credit rating. In exchange for the risk of lending money to a bond issuer with bad credit, the issuer pays the investor a higher interest rate. "High-yield bond" is a nicer name for junk bond.

What is a bond?

When a corporation or municipality borrows money from an investor, it gives the investor a bond. The bond is like an IOU or promissory note -- it states the amount that will be paid back, when it will be paid back, and what interest will be paid on the borrowed money. Bonds come in two grades:

• Investment grade bonds: Those that Standard & Poor's and Moody's rate as carrying no more than medium risk and at least medium quality.
• Junk bonds: Those with high risk and below medium quality, and those in default.

How do I know if a company or municipality has a bad credit rating?

Standard and Poor's and Moody's are the bond-rating systems used most often by investors. Their ratings are as follows:

Should I buy junk bonds?

Never buy individual junk bonds because they are too risky. However, a high-yield bond fund can be a good addition to your portfolio if you do all of the following:

• Hold it for more than five years
• Reinvest the income
• Hold it in a tax-deferred account (IRA, 401(k))
• Make this holding a very small part of your portfolio. No more than 20 percent of your bond money should be in junk bonds

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.