Monday, February 15, 2010

What Exactly Is A Junk Bond?

"Junk" bonds are defined as those which carry a credit rating of BA+ and below by Moody's, or BB+ and below by Standard & Poors.   This definition is somewhat arbitrary and both of these rating agencies have been tarnished in the last couple of years.  Both gave out AAA ratings, the highest possible, to a number of issuers only to have them default.

The list of idiotic ratings includes many Collateralized Bond Obligations (CBOs), which were insured by "mono-line" insurers AMBAC and MBIA - all of which either defaulted or underwent significant restructurings.

Having traded junk bonds in a former lifetime, I used to bristle at the term junk for several reasons.  One, the term is quite perjorative and tars the entire group with the same brush.  Second, junk status does NOT speak to VALUE.  A very low rated company could be a steal, while a high rated company could be tremendously overvalued, as holders of AMBAC and MBIA debt found out in 2008.

Junk bonds are merely part of a continuum of risk in the entire arena of corporate bonds, all of which should be viewed on the basis of risk and return.  At the "high quality" end of the risk spectrum are "investment grade" bonds - those which carry a credit rating of BBB- and above by Standard & Poor's, or BAA- and above by Moody's.  An investment grade rating is incredibly difficult to get - less than HALF of the Fortune 1000 would qualify!

Valuation of any corporate bond is viewed by comparing its "spread over treasuries" to its risk.  The spread is measured as the difference between the yield on the corporate bond and the yield on treasuries corresponding to the same maturity.  A high spread is indicative of attractive potential returns, while a low spread indicates the opposite.

For most investors, buying individual junk bonds, or any corporate bonds for that matter, is very difficult.  Corporate bonds are typically sold in lots of $1 million face value, therefore, one needs at least $20 million to properly diversify that asset class alone!

An interesting Exchange Traded Fund (ETF) exists to allow smaller investors to take a postion in junk bonds.  The ticker is JNK and it's comprised of approximately 100 issuers carrying a combined yield of just over 11%.  It's impossible to assess it's value based on this information alone, since we'd have to analyze the entire basket as to risk and return. 

Concerns about the credit worthiness of the "PIGS" countries ( has weighed heavily on all segments of the corporate bond market, especially junk.  Year-to-date, junk bonds have returned MINUS 1.58%.

Prospectively, given the massive economic problems that lie directly ahead, I would, for the time being AVOID this sector.  Once the economic damage has been done and yields shoot higher, this sector might be worth a look. 

Junk bonds are a very poorly understood asset class, so it made sense to do a little primer of just what makes them tick. 

If you have any questions or comments feel free to TAKE ME ON!

Marko's Take

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