The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly

Chapter 7. High-Yield (Junk) Bonds

The search for higher returns often leads investors to the world of high-yield bonds, also called junk bonds. Junk bonds have lower credit ratings (below BBB from Standard & Poor's and below Baa from Moody's) and higher yields than more creditworthy securities. Those higher yields, of course, are compensation for an investor's willingness to take incremental risks. TABLE 7.1 describes the risks connoted by each rating in more detail.

Note that Moody's describes any bond with a rating of Ba or below as speculative—differentiating it from a sound investment. Logically, the more speculative (risky) the investment, the greater the yield needs to be to entice investors to assume this incremental risk.

A fixed-income instrument plays three primary roles in a portfolio: to serve as a liquid reserve in the event of emergencies; to generate a stable cash flow; and to provide the portfolio with stability, allowing investors to take equity risk.

As we will demonstrate, junk bonds are too risky and too exposed to equity risk to serve these purposes. However, they do possess two other characteristics that should be analyzed before deciding against this asset class.

First, junk bonds offer the potential for high returns. Second, they also exhibit nonperfect correlation (a correlation of less than 1) with equities, U.S. government securities, and the securities of corporate bonds with the highest credit ratings (AAA and AA). This suggests the possibility that junk ...