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-- Posted: Jan. 5, 2000

Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

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:

Moody's Standard & Poor's Grade Risk
Aaa AAA Investment Lowest risk/highest quality
Aa AA Investment Low risk/high quality
A A Investment Low risk/upper medium quality
Baa BBB Investment Medium risk/medium quality
Ba, B BB, B Junk High risk/low quality
Caa, Ca, C CCC, CC, C Junk Highest risk/highly speculative
C D Junk In default

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
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