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Junk Bond Losses

Investment losses in junk bonds or high yield bonds are a very common type of securities fraud. They are known also as high yield bonds because of the higher than market rate coupon they generally pay to compensate investors for the risk they present. They are known as junk because they in many instances can also be just that. Highly speculative and risky securities that are suitable only for certain types of investors. High yield junk bond losses are common among senior investors as bonds are generally more appealing to retirees looking for income with preservation of capital. The biggest losses in corporate junk bonds have been connected to oil and natural gas. This includes:

  • Teekay
  • Transocean
  • Chesapeake
  • First Energy

Investors who have purchased these junk bonds have not only witnessed massive drops in the underlying principal of the bonds but in many instances have also seen bankruptcies and missed interest payments. While some of these corporate entities have seen a mild drop in price, the loss of interest payments can be critical for senior investors who are relying on the monthly income to sustain lifestyle.

How Junk Bonds Function

To start bonds in general are a debt security. An I.O.U that can be generated from a corporate or municipal entity. In exchange for giving money to a municipal or corporate entity the entity pays a coupon generally on a semiannual basis to investors. Bonds pay a coupon payment to investors that is known as the bonds yield. The bonds generally have a maturity date and a call date. The call date is when the bond issuer may call the bond away giving the investor his principal back. When the call date on a bond passes the bond issuer has the right but not the obligation to return the principal to the investor. The maturity date is when the bonds have to be returned to the investor. The longer the maturity date the higher the yield on the bonds. A bond maturing 10 years away yields much less then a bond maturing in thirty years. High yield junk bonds are of course also appealing because they offer yields well above market rates.

Junk Bonds are rated below investment grade. This is anything below Baa3 by Moodys and BBB- by Fitch and Standard and Poors.

Historic Lows in Bonds Causing Investors to Seek Junk Bonds

Bond rates now are in historic lows in the market with the benchmark market rate for the 30 year US Treasury Bonds below 3%. This is what makes the market for junk bonds so appealing to many investors. These investors seeking yield and looking for higher returns are more tempted to seek out junk bonds.

Municipal junk bonds have even greater appeal because of their tax free feature. Since the yield on the bonds is exempt from federal and state tax the real rate of return on the bonds is higher than what the actual coupon on the yield states. For instance, the yield on a bond with a coupon of 5% for an investor in a 30% tax bracket is over 8%.

Junk Bond Risks

There are a number of risks that are carried by investors who purchase high yield speculative junk bonds.

Default Risk

The most alarming risk is that the junk bond can default. This can happen if the entity issuing the bonds files for bankruptcy. Historically this was much more common with corporate junk bonds. When the corporate entity filed for Chapter 11 – investors who purchased bonds would lose everything they put in - their principal and coupon. Defaults have become more common with municipal bonds as well with the City of Detroit as well as Puerto Rico both defaulting and filing for bankruptcy protection.

Interest Rate Risk

For bonds with longer maturities the biggest risk that many investors face is losing principal when interest rates climb. The longer the maturity of the bond the greater the risk. For bonds maturing in over 30 years the price of the bonds will drop substantially more as opposed to investors who purchase bonds maturing in 10 years. The issue is many investors have been chasing yield and investing in higher yielding bonds in order to generate a higher rate of return.

As stated bonds are generally much more appealing to senior investors as they offer safety of principal and a set coupon payment. They are generally considered much more suitable to investors who are retirees looking to avoid the volatility of the stock market.

The issue with junk bonds as well as bonds with longer maturities that carry interest rate risk is that many of the risks of these bonds are not explained to investors. Placing too much of an investors assets into these junk bonds may be extremely risky and unsuitable. The problem is that many investors continue to hunt for yield as rates remain low plowing into junk bonds and bonds with longer maturities.

As with all other claims for investment fraud whether there is a claim to recover losses will depend on the individual facts of the case such as the investors investment profile, risk tolerance, and investment objectives. What the investors were stating to the broker is also very material. In many instances investors may have been demanding high yielding bonds to make up for low yields. The sophistication and knowledge of the investor of junk bonds and experience in fixed income securities will also be relevant. Demand for higher yield into junk bonds may not be fatal to a case but will be material in assessing the strength of the case and the total return in damages that can be netted by the aggrieved investor.

If you are an investor who has lost money in junk bonds please contact the securities attorneys of Lubiner Schmidt and Palumbo for a consultation.

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