Junk bonds continue to receive a lot of media attention in 2016, but one of the most common questions we've been receiving is "what are junk bonds?" Investors know they are risky, but most don't how these bonds actually work.
Here's your complete answer - plus three other investment options that are much safer than junk bonds...
The short answer is that junk bonds are just like regular bonds.
A bond acts as an IOU between a company and a purchaser. The company uses the cash that is provided up front to finance projects and plans to help the business grow. The company issuing the bond will set a date that the bond will mature and state the interest it will pay for the bond. Then, it will eventually pay the purchaser their principle, plus the interest, on the date set.
But here's where junk bonds differ...
Investment-grade bonds are given ratings from AAA to BBB. Bonds with high credit ratings generally do not offer high returns, but the risk of the company defaulting on the bond is much smaller. Microsoft Corp. (Nasdaq: MSFT) received an AAA rating from Moody's when it issued $10.8 billion in new bonds in 2015, according to Zacks. But a Microsoft bond maturing in 2016 has a return of just 2.5%, according to investment research firm Morningstar.
Junk bonds are generally rated BB or lower by Standard and Poor's and Ba from Moody's.
So why would anyone want to invest in junk bonds? Well, the return on junk bonds is much higher than investment-grade bonds. However, there is also a higher risk of the company not being able to pay investors back. The default rate for junk bonds soared 45% from 2014 to 2015.
While the promise of high-yielding returns is alluring, retail investors should stay away from the junk bond market.
First, investing in junk bonds means that you have to be comfortable with never receiving your money back. If the company goes bankrupt, you will not only lose your yield, but you will also lose your entire principal. The lower yields of investment-grade bonds aren't as exciting, but it's better to slowly grow your money than to watch it completely disappear.
Second, junk bonds require a deep understanding of specialized credit because it's important to weigh the risk and reward. Wealthier investors can pay for junk bonds because they can afford to lose the money as well as give their money to funds or firms who specialize in the area.
In fact, Money Morning Global Credit Strategist Michael Lewitt called junk bonds a "disaster zone" earlier this week.
The returns on junk bonds may seem attractive, but we have three much better options to protect your wealth in 2016...
Avoid Junk Bonds, Invest in These Three Options Instead
Lewitt believes that we are in a bear market that "has further to run," and he doesn't want Money Morning readers to get swept up in short-term rallies.
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"Readers should not let their guards down and let themselves get fooled into diving back into dangerous waters," Lewitt warns. "If they do, they will drown."
As we mentioned, there are three very specific opportunities for our readers to protect their wealth and make investing profitable.
The first opportunity Lewitt believes in is cash. Inflation is always a concern, but having cash is one way to protect your wealth when markets are volatile. Over the last week, the strength of the dollar has risen 10.35%, while the euro and British pound have fallen 11.45% and 26.16%, respectively.
The second option Lewitt recommends is buying gold. Last week, gold prices saw their biggest weekly gain since 2008. Whether it's owning physical gold or investing in gold securities, Lewitt has provided our readers with several ways to invest in gold.
Finally, Lewitt believes U.S. Treasuries are the one of the best plays to make right now. Treasuries help reduce volatility in your portfolio, and Treasuries with short-term durations (how long the bond takes to mature) will actually provide you with a higher return if the Fed lowers interest rates. Money Morning Chief Investment Strategist Keith Fitz-Gerald covers Treasuries in-depth here.
The Bottom Line: Junk bonds offer a high reward, but bearish stock markets make it too risky to own junk bonds for the average investor. Instead, Money Morning Global Credit Strategist and hedge fund manager Michael Lewitt believes your better options are cash, gold, and Treasuries.
Jack Delaney is an associate editor for Money Morning. You can follow him on Twitter and follow Money Morning on Facebook.
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