Health & Fitness
Buying "Junk"
“Junk” usually has a negative connotation. Sub-par, low quality or just plain old bad are usually some of the adjectives that come to mind when you hear the word junk. That, or garage sales, where, although there might occasionally be a gem, most of the material for sale is of questionable value – even to the person holding the garage sale!
In investing, however, the term “junk” can be music to some people’s ears. The era of the junk bond coincided with the “M&A ‘80s,” and this is no accident – in this era of mergers, acquisitions, and hostile takeovers, there was a need for financing that traditional financing institutions (banks) were not providing. To provide the liquidity (cash) necessary to execute all these financial maneuvers, firms began to issue “junk bonds.” In this case, junk bonds meant that the debt was not secured by anything, i.e., they are the opposite of a secured debt issuance, which is backed by assets of the firm and ranks higher in the pecking order of recoverability.
Junk bonds are once again in vogue, as the articles I have linked to below discuss, but I am more interested in the why as opposed to the what. Why would high-yielding, and more risky, bonds be back in style and be attracting the massive inflows they have been?
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The answer is two-fold, but the two parts are interrelated.
On one hand, lending by financial institutions has still not recovered to pre-recession levels, and any incremental growth been sluggish at best. Obviously, if the banks are not lending to firms, the firms need to find alternatives – if you look at the number of firms that have issued their own debt since the financial crisis, it might boggle the mind. Secondly, these firms can afford to issue their own debt, and junk bonds can pay lower rates due to the fact that we are in a depressed interest rate environment. This is partially due to sluggish economic growth and partially due to the Federal Reserve’s policy of quantitative easing (QE) that has kept yields on government debt (a benchmark for many other instruments) artificially low.
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This all makes for a great intellectual conversation, but what does this mean for you?
It means that while high-yield is appetizing in the current environment, it is important to remember that, with high yield, comes higher probability of default. Just as high-yielding dividend stocks contain the risk of dividend cuts, high yield bonds, aka junk bonds, contain a probability of default, and this default risk is much higher than non-junk-rated debt. Although the phrase junk bonds may have been replaced with the more palatable “high yield,” the fundamental structure of the instrument remains the same.
In investing, and life in general, there are greater rewards for taking greater risks – you just need to be sure that you and your money are being compensated for the increased risk you are assuming.
Happy Reading!
http://www.cnbc.com/id/100948111
http://www.cnbc.com/id/100916914
http://article.wn.com/view/2013/04/19/Is_High_Yield_Overvalued/#/video
