Unlike stocks, bonds are graded by independent rating agencies. The bonds that receive sufficiently high grades are broadly referred to as investment-grade bonds. Those that fail to get a passing grade are referred to as high-yield bonds, also known as junk bonds in the financial news media. Naturally, high-yield bonds carry significant risk and must be approached with caution. However, they can have a place in even a relatively conservative portfolio.
A bond rating is a letter grade assigned to the bond by an independent, trusted rating agency. There are three major rating agencies: Standard and Poor's, Moody's and Fitch. While their grading systems differ slightly, AAA always stands for the highest grade, denoting the safest bonds with the lowest risk of financial distress. Subsequent letters represent lower grades and higher risks. Bonds that are rated below Baa by Moody's or BBB by Standard and Poor's and Fitch are classified as high-grade or junk bonds. A bond's issuer must pay a fee to obtain a rating. Unrated bonds are available, but individual investors should stay away from them. There simply is not enough information available on an unrated bond to make an informed investment decision.
An investment-grade bond has a fairly low risk of default. The rating agencies do not publicize an expected chance of probability, but assigning a rating of BBB or higher to a bond means that the company issuing the bond is managed prudently and has sufficient resources to weather the ups and downs that companies tend to face under normal conditions. These bonds are usually issued by established and well-known companies, such as Microsoft, Exxon Mobil or Home Depot. Due to their relative safety, these bonds do not have to offer a high rate of return to lure investors. In most cases, these bonds promise an annual return only a few points above entirely risk-free government bonds.
Bonds that have failed to obtain an investment grade rating offer a high rate of return -- or a high yield -- because this is the only way to convince investors to take the associated default risk. There is a very real possibility that the bond's issuer will fail to make the coupon or principal repayment. If the investor's gamble pays off, however, the returns can justify the many sleepless nights. It is not uncommon for such bonds to yield in the double digits while investment-grade bonds offer only half as much.
Picking the Winners
Investors seeking an essentially risk-free portfolio should definitely stay away from high-yield bonds and invest primarily in those issued by the federal government or the highest rated blue chip companies. If you can tolerate some risk, however, investing a small portion of your portfolio in high-yield bonds could be an option. A basic rule of thumb is to stay away from the high-yield market when the economy is shrinking. Life is already hard for these firms and a deterioration in the economic climate tends to push many of them into bankruptcy. If you expect an economic boom, however, a closer look at the high-yield market might be warranted.
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