As we have seen in earlier posts, a bond is a loan made to a government or corporation with the borrower obligated to pay back the principal with interest at maturity. The creditworthiness of the borrower (bond issuer) is reflected in the bond’s credit rating; the better the ability of the issuer to meet their debt obligation, the higher the credit quality of the bond.
Bonds with superior long-term credit ratings (AAA, AA+, AA, etc.) are known as prime or high-grade bonds. These bonds are issued by companies with a solid track record and the high rating is a testament to the issuer’s ability.
On the contrary, there are some corporations that have a poor record of meeting their debt payments (whether late or default) or do not have a long history but still need money to finance their activities. Since investors would be unwilling to part with their cash for such a corporation’s bond, the company will have to lure investors through their high bond interest rates. Due to the speculative nature of such bonds, they are called junk bonds or, to put a positive spin, high-yield bonds. Usually, the credit rating of such junk bonds are BB, B+, B-, CCC, etc. to reflect the potential risk of default.
Junk bonds in the current interest rate environment
Until a few years ago, the Canadian junk bond market was virtually non-existent after it went into a dormant state in 1990 and companies sought refuge in the established US junk bond market. However, due to the current low interest rate environment, a few companies have started borrowing in Canada by issuing junk bonds; a short list of junk bond issuers is available here (second page of above link). A point of note for junk bonds is the yield spread; in other words, the difference in yield between a junk bond and government debt. The yield spread is important as it helps in identifying whether the reward (higher yield) outweighs the risk (default).
Junk bond ETFs
As with other asset classes, junk bonds are also available as ETFs to help mitigate the impact of default that gains focus when buying a few individual junk bonds. iShares iBoxx High Yield Corporate Bond Fund (ticker: HYG), SPDR Barclays Capital High Yield Bond Fund (ticker: JNK), and PowerShares Fundamental High Yield Corporate Bond Fund (ticker: PHB) are some of the options available to investors interested in going this route.
A short list of high-yield junk bond ETFs is available at ETFdb. As the stock markets alternate between fear and confidence, the market rallies have fueled the performance of such junk bond ETFs. Nonetheless, the pickings seem slim in the Canadian junk bond category with the AGF Canadian High Yield Bond Fund being the prominent player.
Similar to other bond ETFs, it would be useful to look at the liquidity, expense ratio, default rate, yield spread, fund composition, and direction of the fund (strategic changes) when looking to invest in junk bond ETFs.
Are junk bonds for the average investor?
As should be evident from above, the risk with junk bonds is that the investor may never get their principal back due to the poor creditworthiness of such bond issuers. In addition, if looking for individual junk bonds, the investor should be fairly knowledgeable about credit quality. Typically, institutional investors have the resources to conduct elaborate research to filter the better ones. Although an average retail investor may get the chance to diversify across different asset classes by buying some of these high-yield junk bond ETFs, the risk may not be worth their while.
Do you invest in junk bonds? Individual or ETF? How have your investments fared? Do you have any tips to offer for interested investors?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.