High Yield Bonds Also Known As “Junk Bonds“
High-yield bonds that rated below investment grade are also known as "junk bonds." They typically pay higher yields than better quality bonds, making them attractive to investors, but are considerably more prone to be affected by interest rate risk and credit risk causing them to have a higher risk of default. Credit rating agencies consider anything BBB- or higher to be investment grade bonds. Those rated lower on their issue date are called "junk bonds" or "speculative grade bonds." Generally, pension funds and institutional investors are prohibited from investing in bonds that are not at least investment grade rated.
Red flags would be raised and investors would normally be skeptical of investing in something readily known as "junk bonds." Unfortunately, these high yield bonds are more often not easily discernible when they have been repackaged into opaque collateralized debt obligations (CDO) in order to raise the ratings of the senior tranches above the rating of the original debt. These products represent a serious problem for investors because of their complexity, making it very difficult to understand that such CDOs, such as subprime mortgage loans, are backed by assets of dubious value. Holding theses "toxic" assets ultimately led to the demise of Lehman Brothers and other financial institutions in the worst economic crisis since the Great Depression. Testimony and data recently provided to the Financial Crisis Inquiry Commission (FCIC), a panel established by Congress to investigate the worst financial crisis since the Great Depression, revealed that as much as 28% of the loans failed to meet even basic underwriting guidelines. The information was given to Wall Street banks that ignored the red flags, purchased the loans anyway, bundled them into securitized pools, and sold to investors.
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