Today, they're called junk bonds. Until the recent wave of public interest, they were more decorously known as "high-yielding bonds."
Either way, they're bonds with a lot more risk than a Triple A issue -- and a tempting yield that's 3 to 5 percentage points higher than the yield on Treasury bonds. With long-term Treasuries at around 10 percent today, junkers are running in the area of 13 to 15 percent.
So here's the first question for investors: Is that great big yield worth the ever-present risk that the company might default?
As an individual, you're not likely to buy a single junk issue, because the initial investment is usually too high (in the area of $25,000 to $100,000). Besides, if the company fell off the cliff, your whole investment would fall with it.
But studies of the junk bond market suggest that if you buy into a broad number of issues -- through a mutual fund or a unit trust -- you might do very well indeed. And your initial investment may be as little as $1,000.
New York University professor Edward I. Altman found that, measured by dollar volume, 1.5 percent of junk bonds defaulted annually over the past 10 years -- a rate twenty-fold higher than the 0.08 percent failure among corporate bonds overall. But even counting defaults, high-yielding bonds nicely outperformed Treasuries between 1978 and 1983.
Similar results have been found in other studies.
Nearly 40 mutual funds -- known as high-yield bond funds -- now buy lower-rated bonds for their portfolios. Some invest heavily in these issues; others balance their risks with substantial portfolios of top-rated bonds and Treasury issues. Some of these funds buy and hold a goodly number of their bonds; others trade bonds aggressively, turning over their entire portfolio every year.
Over the past 10 years, the regular high-yield funds returned an average of 10 percent a year to their investors, despite occasional defaults. The aggressively traded funds yielded 10.2 percent. By contrast, A-rated bond funds returned an average of 9.5 percent, according to Lipper Analytical Services.
Recently, however, A-rated funds have improved their relative performance -- returning 15 percent in the 12 months ending March 31, roughly the same as the regular high-yield funds. The aggressively traded funds pulled way ahead to 16.3 percent. So for higher yields, you now have to invest in the most speculative end of the market.
This brings up the second question for investors: Is something happening to junk bonds to make them less attractive than they used to be?
The junk bond market has been changing fast. Formerly, it was made up largely of bonds from once top-rated companies that had fallen, temporarily, on hard times. But last year, low-rated companies started issuing new bonds that were junkers right from the start.
Some of these bonds finance risky, newer companies. Others finance risky corporate takeovers. In takeovers, your bond interest may be payable from the proceeds of selling some of the company's assets at a high price. If those assets bring a lower price, the issuer may be forced to default.
Consequently, high-yielding bond funds today probably are carrying a higher burden of risk. Yet because of their popularity, investors are rushing to buy -- resulting in yields that are too low in relation to the yields on top-rated funds.
Fund expert Michael Lipper says that he is avoiding junk bond funds today. "I don't like to buy straw hats in the summer," he says. "When everybody is doing something, it's usually wrong." He thinks that the funds are not paying enough more than A-rated funds to be worth the risk.
Lipper also raises questions about the past performance record of junk bond funds. "They tend to have intermediate-term bonds, while the A-rated funds have more long-term bonds," he says. "In the past 10 years, intermediate-term bonds did better, and that might account for the good performance record. It may be that lower-rated credits, by themselves, are not as good as the record suggests."
No fund will advertise that it buys "junk." Instead, it usually defines itself as "aggressive" or "high-yield." The prospectus will tell the story: A certain portion of the portfolio will be invested in bonds rated BB or Baa and lower, which are considered below the normal investment grade.