With many Americans starting their retirement savings later on in life, and generally low savings rates, many investors are under pressure to maximize their investment gains using any means possible. Lower-quality bonds, also referred to as junk bonds, and using leverage, or borrowing money to invest, are two methods available for investors. You must carefully consider all potential outcomes before choosing to use any investment strategy, particularly when considering aggressive, high-risk investments.
Potentially Higher Yields
Junk bond issuers pay higher interest rates on their bonds because they are viewed as a higher credit risk by investors or bond-rating services than other corporate or government bonds. Many of these junk-bond issuers are still fully capable of paying their bond interest and paying their principal as they have agreed to, but the only way they can borrow money is by issuing higher risk bonds. Higher interest rates are the trade-off to investors for the higher risk.
Other People's Money
Leverage is borrowing money to invest in order to potentially increase your return on investment. For example, if you invest $10,000 of your own money in junk bonds, and borrow an additional $10,000 to invest, it is the same thing as if you have invested $20,000. If you invest in junk bonds paying 10 percent, you will earn $2,000 on your total investment. Your net return is then 20 percent, as you earned $2,000 on your investment of $20,000. In addition, interest paid on money borrowed to invest may be tax deductible. Careful use of leverage can be part of an aggressive investment portfolio.
Some experts believe the recent performance of junk bonds is because of low interest rates set by the federal reserve. These rates are likely to rise in the future as economic conditions change. With this increase in rates, junk bond prices will be forced lower, as other investments are now paying more comparable rates with less risk to the investor. In addition, the companies issuing the junk bonds may experience financial difficulty as their debt with other lenders must be refinanced at a higher interest rate, causing difficulty for the companies as the higher expenses for debt service eat into profits.
The higher yield potential afforded by leverage also increases the risk of loss. If you lose money on a leveraged investment, you will still be left with a loan to pay back, in addition to the loss of your own money. When coupled with the increased risk of junk bonds, you need to consider carefully if using leverage to purchase junk bonds is an effective strategy for long-term financial health.