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Junk bond

 

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Junk bond is a business term referring to a debt instrument (bond) that has a higher risk of defaulting. They typically pay high yields in order to make them attractive to investors. The term "junk" is considered pejorative, and these instruments are more often referred to as high yield bond or non-investment grade bonds.

In modern economies, debt is bought and sold in the form of bonds traded in organized markets. The price of a bond is determined by numerous factors, including the interest rate, the term (amount of time before the bond is paid back in full, also known as the time to maturity) and the degree of risk associated with the underlying assets.

Risk
The risk of a bond is a measure of the ability of the debtor to pay the interest payments (or coupons) and eventually pay off the complete debt when the bond matures. Companies with financial difficulties will find this more difficult, and are considered a more risky investment than bonds issued by, say, the US treasury which are considered risk free. The risk of a bond is determined by one of several credit rating agencies such as Standard and Poor's and is expressed by a rating such as 'AAA' (where 'A' is better than 'B' and 'AA' is better than 'A').

Bonds rated below 'BBB' are called 'junk' bonds. Bonds rated 'BBB' and higher are called investment grade bonds. This lower rating typically implies a higher yield, making junk bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors, however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. In some cases this can lead to a dismal cycle in that a company with financial difficulties will have its bond rating lowered which will make it harder to raise money thereby deepening its financial troubles.

This cycle was one (but not the only) factor that accounts for the sudden collapse of several high profile companies such as Enron and WorldCom, whose bonds were not initially rated junk.

The value of junk bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates tend to drop, this tends to increase the value of investment grade bonds, however a recession increases the possibility of default in junk bonds.

Junk bonds were popularized in the 1980s by Michael Milken as a financing mechanism primarily for mergers and acquisitions. In a leveraged buyout (or LBO) an acquirer would issue junk bonds to pay for a corporate acquisition and then use the cash flow of the target company to pay off the debt over time. However new regulations and better strategies on the parts of the companies have reduced the use of LBO's since the 1980s.

However, junk bonds are still used to finance capital intensive industries such as telecommunications. Interestingly the bonds of companies such as Enron and WorldCom were not rated as junk, partly because the companies hid much of their debt in off balance-sheet transactions, so that the financial instability of the company wasn't known to credit rating groups.

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