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How Investors Find Treasure in Junk Bonds

By Lou Carlozo

Shopping for junk doesn't exactly have a luxurious ring to it, whether you're hitting a salvage yard for a '62 Ford Falcon horn or combing through VHS tapes of "Sweatin' to the Oldies" at a rummage sale. So think about it: Why would anyone buy a product called a junk bond – conceived, after all, by that legendary felon Michael "the Junk Bond King" Milken?

As fine a question as that might sound, it overlooks the obvious. Wall Street, that funny little financial district where irrational exuberance is king, bases a good part of its existence on curious ways to wealth. So people not only invest in junk bonds, they can also buy exchange-traded funds that deal in them. The SPDR Barclays Capital High Yield Bond even has a cheeky stock exchange ticker to go with it: JNK.

So how do junk bonds work? Three ratings agencies assign grades to bonds, with AAA or Aaa being the highest, also known as prime. When an investment falls below BBB- (Standard & Poors, Fitch) or Baa3 (Moody's), it becomes junk as opposed to investment grade. Yet even within junk status, there are four risk tiers before a company hits partial or full default.

"High-yield bonds are a source of debt financing from public corporations that are assigned 'below investment grade' ratings from credit rating agencies," says Loren Asmus III, vice president, investment research at Canterbury Consulting and based in Newport Beach, California. "Investors are assuming more credit risk but to achieve potentially higher returns."

Read the full article here.