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Know Junk Bond Before
You Invest
A junk bond is typically a high-interest loan
with relatively unfavorable terms to compensate for a
high risk of default. Junk bonds are a type of
high-yield debt, and by far the most common.
Bonds are rated according to the credit rating of the
borrower. In the US, the major rating agencies are
Fitch, Standard and Poor’s, and Moody’s. The
rating scheme in descending order of value is: AAA,
AA, A, BBB, BB, B, CCC, CC, C, D. Anything rated BB or
below is generally considered to be a junk bond
because the credit risk is so great.
In the modern economy, bonds are traded like any
commodity. Investment companies try to maximize their
profit by balancing the safety of an investment with
the cost of the bond on the market. Junk bonds are
very attractive to some investment groups because of
their low cost.
In some cases, an investor may be prohibited by the
bylaws of the group they belong to, such as a company
pension fund, from purchasing any bonds rated below A
or BB. This limitation makes the junk bond market
considerably more limited than the market for
high-graded bonds, commonly referred to as
investment-grade bonds.
The use of the junk bond is widespread throughout
sectors that require significant amounts of capital to
operate. The telecommunications and energy sectors are
two industries which utilize the junk bond
extensively. Recently it has come to light that a
number of companies have manipulated the appearance of
their debt to help them receive a higher rating on
their bonds so they could more easily trade them on
the market.
Enron is probably the best known example of a company
distorting apparent debt to make their portfolio not
consist primarily of junk bonds. By hiding much of
their debt off-book, Enron received higher ratings
than they would otherwise have earned. WorldCom,
similarly, was initially not rated as a junk bond
company because of illicit accounting practices.
The junk bond also plays an important role in the
leveraged buyout and hostile takeover, allowing groups
of investment bankers to raise large amounts of
capital to use in acquiring a target corporation,
paying off the junk bond interest with the newly
acquired corporation’s cash flow.
By Brendan McGuigan
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