Junk Bonds

This week I was reading a story on The Economist about junk bonds. What are they? What are the advantages and disadvantages in buying them? Who uses junk bonds? I'll try to answer these questions in this post, I hope you enjoy it.

Junk Bonds are corporate debt securities, usually, with high credit risk, as indicated by Moody's (lower than Baa3) and Standard & Poor's (lower than BBB-). These kind of bond have a higher risk of default and in order to make it atractive to investors, it offers higher yields than better quality bonds.

Junk bonds offers companies several distinct advantages over other types of financing as equity dilution resulted from the issuance of new common shares. Bonds also can be less costly source of funds on after-tax basis than equity. On the other hand is the higher level of fixed charges that results from issuing bonds.The companies have to comply with the local comission (SEC for example) by giving a lot of information as financial reports, that companies may not wish to give for competitive reasons for example.

For the investor's viewpoint, these bonds can provide high income and a big potencial for capital gains. The word 'can' in the last phrase have a significance. The junk bonds is subject to a lot of high risks making the possibility of a default much higher than a investment-grade bond.

Besides, there are other people who use bonds. Funds are a great exemple of it. There are funds dadicated just to high-yield securities providing a diversification benefit. Other types of mutual funds also invest in high-yield bonds. Medium quality corporate bonds funds are typically permitted, by the provisions of their prospectuses, to allocate a portion of their assets to securities rated lower than Baa3/BBB-. This latitude enables the funds to raise the overall yield on their portfolios. Another category of high-yield investor includes "asset allocation funds," which achieve diversification by combining noninvestment-grade holdings with other fixed-income investments such as foreign bonds or mortgage-backed securities. Some equity mutual fund managers participate in the high-yield market as well. Their objectives include speculating in specific issues and increasing the income in their funds during periods in which the stock market offers little potential for capital gains.