What Are Junk Bonds, And Why Did We Decide To Invest In One?

Today, we wanted to give you an introduction to bond investing, and in particular, Junk Bonds, also know as High-Yield Bonds. As I’ve mentioned previously, we’ve been looking for ways to diversify our portfolio a bit more from being almost entirely equities (stocks). That is why we started to research bonds.

Surprisingly, even though there is a lot of general information about bonds and investing in bond mutual funds and ETFs, I wasn’t able to come across anyone who was investing in individual offerings, so hopefully this is a helpful post to a lot of you.

For more investment articles, go here.

What is a Bond?

A bond is debt that a corporation or government entity offers for a fixed time frame, at a fixed interest rate. This interest is typically paid out twice a year until the bond matures. Then the final interest payment is made along with the original principal to the bond holder (debt owner).

Bonds receive a rating between Aaa/AAA and C/C which is based on how much risk is perceived by the rating agency. Aaa/AAA is best, and C/C is the worst a company can have without being in default (aka: without missing a payment). The two ratings separated by a “/” are Moody’s and S&P’s respectively.

A bond is typically sold in increments of $1,000, but many brokerages will require a minimum purchase of 5 notes. So for instance, you could purchase $7,000 worth of notes (7 notes) but not $2,000 worth of notes (2 notes).

When purchasing notes on the open market, you can either pay a discount, par value, or premium to the original note value. Notes will go up and down in value depending on federal interest rates, company outlook, etc.

What Are Junk Bonds?

Junk bonds is a subset of bonds. They are bonds from companies that may have a lot of debt, some sort of financial distress, or any other number of reasons why they are considered higher risk.

The interest rates of these bonds are usually much higher than investment grade bonds (or bonds from companies with the highest credit ratings). This is why they are often called High-Yield. Typically, anything rated Ba/BB to C/C is considered a Junk or High-Yield Bond.

The Investment Process

So now that you have some idea of what they are, we’re going to walk you through an example purchase. Below is an example of a corporate bond that is currently available for sale as of this writing:

How to Purchase Junk Bonds
An Order Form For Purchasing Junk Bonds

There are some things to consider here:

  • Company Owing the Debt: Clear Channel Communications, a company many people know of
  • Ratings: Ca/CC, quite low rating
  • Maturity: January 15, 2018, principal is due, plus last interest payment
  • Price: 60.390, this is a bit misleading…it’s more of a ratio. Price multiplied by $1,000 gets the cost per note, or $603.90.
  • Current Yield: 16.559%
  • Yield to Mat/Yield to Worst: 227.654%, assuming they pay back everything thing, this is the total return on an annual basis. Yield to Worst is different if the note could be paid back early, but at this point, there is only one more payment left.

You’ll want to get your hands on any Rating Agency Reports you can (like the one shown as a link in the corner of the picture). Plus, you’d want to read any Quarterly Reports and see how management feels the prospects are for the company.

If we want to buy 5 notes, instead of $5,000, it will cost us $3019.50 plus we have to cover the sellers interest to date of $100.00. We get that back when the next interest payment is made.

So our potential return if everything works out is $5,413.98 for a gain of $2,294.48 in 4 months when the notes are due in full. Whether that makes sense to purchase or not requires some investigation.

Why We invested in Junk Bonds

The risks are higher with a corporate Junk Bonds, but if you do your research, they can provide great returns. Some of them are significantly discounted from their original value which can give you the potential of a high interest rate and capital appreciation when the principal is paid back (as seen in the previous example).

Because of these reasons and others, we decided to take a small portion of our net worth and risk it on purchasing Junk Bonds after doing some research on the health of the company and its ability to pay.

What We Invested In – The Important Facts

We came across this opportunity at the end of August, and the purchase was made on August 31st. The notes were available with the following stats:

  • Company Owing the Debt: Claire’s Stores, a company that my wife used a lot in her youth and has fond memories of
  • Ratings: C/C, lowest rating without a default
  • Maturity: March 15, 2019, principal is due, plus last interest payment
  • Price: 13.098, again, price multiplied by $1,000 gives us a cost per note of $130.98.
  • Current Yield: 67.758%, high returns equal high risk…
  • Yield to Mat/Yield to Worst: 229.774%, assuming they pay back everything thing, this is the total return on an annual basis.

We wanted to invest about $5,000. Each note cost $130.98 plus the interest owed to that point, so we ended up considering a purchase of 28 notes (or the equivalent of $28,000 in principal). That equated to $3,667.44 for the notes and $1,180.37 for the interest owed to the seller for a grand total of $4,847.81.

What We Invested In – The Fundamental Research

We first looked at the Rating Agency Report. It showed that a year ago they were rated approximately the same. It had mentioned hope that some of the debt would be modified, which would put the company in a much better place financially.

We then read the last two Quarterly Reports. Both of them mentioned that the debt restructuring had gone through and that it had eliminated about $500 million off their books.

The more recent one (end of August) showed improvement in their overall business results from the one before.

And probably the best information of all was this quote from management:

“We currently anticipate that cash on hand, cash generated from operations and borrowings under our ABL Credit Facility and U.S. Credit Facility will be sufficient to allow us to satisfy payments of interest on our indebtedness, to fund new store expenditures, and meet working capital requirements over the near-term.”

Though they did follow up with an additional warning about the principal:

“Repayment of our debt as it matures will require refinancing, and we cannot make assurances that we will have the financial resources required to obtain, or that the conditions of the capital markets will support, any future refinancing, replacement or restructuring of our indebtedness.”

So the interest payments should be fine based on this information, but the final principal payment is not a sure thing. Based on all this information, we were still quite hesitant to invest. After all, this is not a CD or savings account we’re talking about!

What We Invested In – The Math That Sealed The Deal

We were a bit stuck, so we went to our friend, Mr. Math. Here’s what we knew:

  • There are two interest payments every year: one in September and one in March.
  • Each interest payment would be $1,242.50.
  • There were four interest payments remaining: Sept. 2017, Mar. 2018, Sept. 2018, and Mar. 2019.
  • The principal payment is due in March of 2019.

With this knowledge, we determined that if we were paid all 4 interest payments, there would be a net gain of $122.19…the interest paid 4 x $1,242.50 = $4,970 minus what we spent $4,847.81.

PLUS, if they happened to be able to pay back the principal by refinancing, continued business improvement, or by some other means, we’d gain an additional $28,000! Even if they aren’t able to pay the principal back, there’s a good chance of getting a partial payment, which is still all a net gain to us.

So the question for us was, do we think they’ll be able to make all the interest payments? Based on the information from the quarterly report, we decided we had confidence in them making all of their interest payments, so the investment was worth the risk.

Where Are We Now?

You may have noticed that the first of four payments was due this month…September 15th to be precise. The day came and went without payment. We got a bit nervous, since usually dividends show up in our brokerage account on the day they say they are paid. Did we take too big of a risk?!?

This is the first bond we have ever held, so we contacted our broker. They said it could take up to 3 business days for a bond payment to post to our account. That gave us some relief, and on September 18th, $1,242.50 was deposited in our account! The first payment is secured!

The next payment is due March 15, 2018, so I’ll post an update around then about how things are going.

We still have the interest money in our account while we look for a good opportunity to invest it in, whether that be stocks or another bond.

Questions?

If any of this in unclear, please post a question. I had a lot of fun writing this, and I hope it helps clear up the mysteries of junk bonds.

2 Replies to “What Are Junk Bonds, And Why Did We Decide To Invest In One?”

  1. Thanks for the comment!

    I’ll continue to give a status update on the bond every six months or so, since that is how often we get paid.

    It’s an experiment…I hope it pans out.

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