If you want high risk with high reward, junk bonds might be the investment for you. Also known as "high-yield bonds," junk bonds are corporate bonds issued by companies that are on less stable financial footing. That might include newer, smaller companies that need to raise capital to expand their businesses or established companies facing financial difficulty. Junk bonds pay a much higher yield than investment-grade corporate bonds and Treasury issues.
As an investor, if you have a choice between investing in a bond from a big blue chip company or one from a company you've never heard of, you would probably prefer the one from the blue chip firm. That's why riskier companies must pay higher yields than blue chip companies. If the choice is between a General Motors bond paying 5 percent or an XYZ Corp. bond paying 10 percent, suddenly the junk bond starts to look a lot more enticing.
In reality, very few junk bonds ever default, but the threat is always there, which means that a certain amount of risks goes with the territory. There is also the risk that the company's bonds could be downgraded further, reducing the value of the bonds and making them more difficult to sell on the secondary market. But if the company survives, your returns would be outstanding.
Bonds rated BBB or higher by Standard & Poor's or Duff & Phelps, or Baa by Moody's are considered investment-grade bonds. Anything rated lower would be considered a junk bond.
There is one option that allows you to reduce your risk while still collecting the high returns that junk bonds offer - a junk bond mutual fund. There are dozens of mutual funds that specialize in junk bonds, and they have become very popular with individual investors.
Who should buy junk bonds?
Junk bonds are appropriate for aggressive income-oriented investors interested in a high rate of return as part of a diversified portfolio. However, because junk bonds pay fully taxable interest, unless you need the income, it would be best to use junk bonds in your tax-deferred retirement account.
Who should not buy junk bonds?
If you don't want income, junk bonds are not for you. If you do want income, buy you want it with a minimum of risk, junk bonds would not be an appropriate investment. However, a junk bond mutual fund would be a much safer investment, while still providing a very high rate of return. Even for conservative investors, a junk bond fund would be a suitable investment as a small part of a diversified portfolio. But if you don't need income, you might want to use a junk bond fund in your tax-deferred retirement account.
