What in the world is a junk bond?
By David Snow • Bankrate.com

Say you're approached by three people asking to borrow $1,000. The first is a respected doctor living in your neighborhood. He owns a large house and has a high-paying job. The second, a mild-mannered schoolteacher who owns a smaller house but has a stable job. The third is a friend of a friend who says he's a performance artist, rents an apartment near the train station and swears he'll pay you back once that dude from his support group sends him a check for all the yard work he did.

If you lend money to the third person, that's sort of like buying a junk bond.

With each potential borrower, there is a different likelihood that you'll get your money back. The respectable doctor most certainly will pay you back. The teacher probably will, too, although chances are greater that he may struggle to do so. The performance artist with no discernable income is the most likely of the three to say, "Dude, my uncle needs bail money. I can't pay you back."

The world of corporate lending is a lot like the scenario described above. Instead of asking you for the money directly, though, companies take out loans by issuing bonds. The corporation gets the money it needs up front and pays back the bondholder in regular installments. In order to issue bonds, a company's credit risk must be rated. Just as that doctor in the nice house would probably have a better chance of getting a loan than the performance artist, different companies have different odds of paying back what they borrow.

Similar to the credit reports lenders check out to determine the risk posed when loaning money to individuals, corporations get what are called credit ratings. Rating agencies like Moody's and Standard & Poor's make it their job to predict which companies are most likely to make their payments on time and which are not.

If, for instance, Standard & Poor's decides a company is rock-solid and will have no problem servicing its debt, it gives a bond issued by that company its highest rating -- AAA (that'd be Aaa in the Moody's lexicon). If the bond is slightly less than rock-solid, it gets a AA (or Aa) and it goes down from there to A, then BBB (or Baa from Moody's). The next step is BB (or Ba). and bonds with this rating or lower are considered "speculative grade" or "below investment grade" -- in other words, a junk bond.

Junk bonds are those that the experts feel have a higher than average chance of defaulting. In good economic times, default rates can be as low as 2 percent. These days, with an uncertain future for the U.S. economy, some junk bond experts are predicting default rates as high as 9 percent.

Why would anyone ever invest in the likelihood of not getting paid back? Simple. Money. Since junk bonds are riskier, the amount of annual interest they pay -- what's known in bondspeak as a coupon -- is higher. A bond with a AAA rating might pay 7 percent per year, while a junk bond could pay as much as 13 percent. This points to the root of the more politically correct name for junk bonds -- high-yield bonds -- since, you guessed it, the yields on junk bonds are higher.

In the 1980s, the investment bank Drexel Burnham Lambert virtually invented the modern junk bond market. The firm's West-Coast chief was a self-made multi-millionaire named Michael Milken, who was hailed 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 largely had been invested in by Savings & Loan institutions, went South and sparked the S&L crisis of the late '80s, while simultaneously tainting the junk-bond name.

Back in the '80s junk bonds were famous as a way to pay for the takeover of large corporations. Need $20 billion to take over RJR Nabisco -- as buyout-firm KKR once did? Issue $20 billion in junk bonds. Whoever bought them assumed the risk that the taken-over RJR Nabisco would indeed be able to service all its debts, or at the very least be able to be broken up and sold off. Bad assumption. One of the great debacles about the leveraged buyout boom of the '80s, was that junk bonds for incurred in takeovers almost universally suffered, because the debt loads were far too heavy.

Nowadays, junk bonds are perceived to be legitimate investments -- although debacles still occur. Individual investors who feel comfortable with the high-risk/high-return model can buy them through junk-bond mutual funds, whereby a chunk of money is invested across a number of different bonds, thereby further reducing the risk. (Although no matter who you are, the junk-bond component of your overall portfolio should still be rather small.)

Of course, if you're the kind of person who would just as soon not give that $1,000 to the sketchy guy who lives by the train, junk bonds might not be the investment for you.

-- Posted: Dec. 20, 2000