Is it wise to allocate a portion of one’s portfolio to junk bonds?
Since the 1930s, bank regulators have issued regulations that restrain banks from investing in securities that can be classified as precursors of junk bonds…
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The corporate bonds with good or highly favorable rating grades are classified as “investment-grade bonds” while those with low ratings are called “low-grade” or “speculative” bonds or by their less formal term, “junk bonds” (Becketti, 1990). In other words, based on Becketti (1990), junk bonds, low-grade bonds, and speculative bonds are synonyms.
According to Becketti (1990), a bond may be classified as a junk bond for three reasons. First, the outlook for the company may be highly unfavorable. Second, the issuing company for the bonds may have large or significant debts. Finally or third, is that the company’s legal claim on another firm’s assets which is in default or has serious risks of default may be behind the legal claims of other companies.
However, Taggart pointed out that despite their low-investment grade status, junk bonds are nevertheless classified as “high yield bonds” by “those wishing to avoid pejorative connotations.” It is very important to state, however, that although junk bonds experience more default, they also tend to have higher returns. More recent data are not immediately available. However, for 1974-1985, the default on junk bonds stood at 1.53% compared to 0.09% for all bonds. The 1.53% may be high compared to 0.09% but certainly 1.53% seems low enough. Further, various reports also suggest that annual return for junk bonds was 12.4% compared to 9.7% for all long-term government bonds. (Taggart, 1987, p. 12). In the 1990s, many economic observers have attributed the country’s economic ills to junk bonds (Becketti, 1990, p. 46). Many observers believed that junk bonds and economic ills simultaneously emerged in the 1980s (Becketti, 1990). However, on the observation, the appropriate interpretation is that the market for junk bonds actually became only popular in the 1970s and 1980s but they have been in the US economy for some time (Becketti, 1990). In 1977, new issues of junk bonds in the United States were close to zero but they steadily climbed up to around US$33 billion in 1986 and to around US$30 billion in 1989 (Becketti, 1990). Becketti (1990, p. 48) argued that despite their size in the US economy for close to two decades, “junk bonds are too small a part of the debt market to account for the growth in corporate debt.” Further, Becketti (1990, p. 48) also argued that although junk bonds are riskier than investment-grade bonds, they are “less risky than equities.” Becketti (1990, p. 48) also clarified that “junk bond returns lie between those of investment-grade bonds and equities.” In addition, “junk bonds are more liquid than bank loans and private placements but less liquid than equities” (Becketti, 1990, p. 48). Junk bonds can also provide investors “more control over corporate management” than investment-grade bonds but less control than many financial instruments like equities (Becketti, 1990, p. 48). If one examines the descriptions of Becketti (1990), it should be easy to conclude that junk bonds aren’t too bad after all. Based on the literature that will be examined by this work on the nature of junk bonds and issues related to the acquisition of junk bonds, there is a genuine case for investing in junk bonds as well as improving the situation of the junk bonds market. Junk bonds are risky investments but they can be part of one’s investment strategy for increased wealth. Further, contrary to the view that our
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