A junk bond or high-yield bond is a bond issued by a corporation that pays a higher rate of interest and has a higher risk of default. Companies that issue junk bonds pose a higher credit risk and are given a lower grade by bond rating agencies like Standard and Poors and Moody’s.
The ratings may range from AAA for companies judged to have a sound balance sheet and ability to make the required interest and principal payments to B or Unrated for less creditworthy businesses.
High-yield bond issuers may be judged to have too much debt or experiencing financial difficulties. They may also be smaller or emerging companies with unproven operating histories or in businesses considered as speculative or risky. Also, junk bonds generally are subject to more liquidity risk than investment-grade bonds.
The investor can invest directly in junk bonds through a broker or buy a high yield bond mutual fund or ETF. Brokers must disclose all materials facts and risks about a proposed investment to the potential investor before the investment. Likewise, mutual fund providers and the brokers that sell them have a duty to clearly and accurately explain the risks and strategies of the funds they sell.
Experts say that the performance of a junk/high-yield bond or bond fund is more highly correlated with the stock market and general economic conditions than an investment-grade bond or bond fund.
That is because as the ability of junk bond issuers to make timely interest and principal payments weakens due to economic forces, junk bond investors begin to sell those bonds. For example, junk bonds crashed during the savings and loan crisis in the 1980s, the dot.com crash of 2000-2002, and the financial crisis of 2008-2009.
Junk Bonds Red Flags
Signs that you are invested in a junk bond are a higher yield and a lower credit rating than investment-grade bonds. Junk bonds are called high yield bonds and junk bond mutual funds, and ETFs funds are known as high yield funds. Higher yield comes with a higher risk of loss.
Companies may issue junk bonds because they are emerging companies with little or no track record, or the perceived likelihood of a default is higher than an investment-grade bond issuer. Default essentially means failure to make principal and interest payments as they come due. In other words, junk bond issuers may be, but are not necessarily, less financially sound than investment-grade bond issuers.
Despite the higher risk that comes with a higher yield, a portfolio of junk bonds are not necessarily an inappropriate investment. Diversification of the junk bond portion of an investment portfolio can provide an acceptable level of default risk.
Thus a diversified high yield bond fund may be a suitable component of an investment portfolio as long as it does not result in an overconcentration of high yield bonds in the investor’s overall investment portfolio.
Signs of a Junk Bond Scam Claim
Some junk bond funds use leverage, meaning that the junk bonds that comprise the fund are purchased on margin with borrowed money. Similarly, a broker may sell junk bonds on margin. Margin or leverage increases potential gains and the risk of losses. A security that is purchased on margin presents a risk of loss of more than the principal amount invested because the margin loan must be repaid even if the security goes to zero.
A broker who recommends a junk bond or junk bond fund has a legal duty to explain all of the critical risks as well as the potential benefits. It is not enough for a seller to rely on boilerplate disclosures in a prospectus without taking reasonable steps to ensure that the investor understands the risks.
An example of a junk bond scam involved a high yield bond fund named Oppenheimer Champion Core Bond Fund. According to the SEC, in or about 2008, Oppenheimer used derivatives (total return swaps) to add substantial exposure to commercial mortgage-backed securities (CMBS) exposure and significant leverage to the fund.
The prospectus failed to disclose this practice adequately and was misleading to investors, according to the SEC. Declines in the CMBS market forced Oppenheimer to reduce CMBS exposure. Oppenheimer agreed to pay more than $35 million to settle SEC’s charges.
High-Yield Investment Loss Lawyers
If you have junk bond losses, you should consult with experienced counsel. The Doss Firm attorneys have substantial experience in representing investors in a wide variety of matters, including junk bond losses. Call us for a free and confidential consultation.