Junk Bonds: To buy or not to buy

Essay by GIgirlmelUniversity, Master's October 2006

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Looking at the state of the economy today, many people are examining different options in saving for their financial future not only for themselves but also for their families. Bonds seem to be gaining in popularity, slowly but steadily. One problem is that many don't fully understand what bonds really are. In short, a bond is "an agreement between a organization and an investor"--the investor lends the organization money and is paid back on the date of the bonds' maturity (plus interest).

When you think of investing most investors want a "sure thing"--companies that have a very high probability of making them some money (even though stocks and bonds are never truly a sure thing). So when you, as an investor, hear the term "junk bonds" your face puckers up and twists to the side from the bad taste. Junk bonds, or 'high yield bonds' to be politically correct, are issued "by companies not on firm financial footing" that offer higher interest rates due to their instability.

(Updegraves, 2001) They are basically "an IOU" that states the amount and date a corporation or organization will pay you for the money you invested. Investors suggest if you want to invest in junk bonds to do so and hold them for at least ten years and have no more than one-third of your bond portfolio in these high yield bonds.

So, with junk bonds the catch is, higher returns and higher risks. Conservative investors need not step into this arena--aggressive investors only. What this means is that they pay higher yields but also have a "higher than average risk" of defaulting. In 2004, junk bonds did a lot better than what portfolio managers initially expected, (they gained an average of 9.9%. (Rehak, 2005)) but they are projecting less than spectacular results in...