What to Do if Your Bonds Turn to "Junk"

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What to Do if Your Bonds Turn to "Junk"
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
Updated April 15, 2009

During the current credit crunch, there’s been a sharp rise in the number of companies issuing corporate bonds that have experienced distress, and some even bankruptcy or default. This raises legitimate concerns for investors holding corporate bonds, especially when initially purchased with “investment-grade” ratings when the health of the companies looked more secure.

If you hold bonds that have been downgraded to “junk” status, here are some scenarios to consider. The list is not all-inclusive, and depending on your individual circumstances, you might want to consider other factors as well.

What can happen when a bond turns to "junk"?
“Speculative-grade” is the term generally used for bonds rated BB/Ba or below by one of the three major rating agencies: Moody's, Standard & Poor’s and Fitch. They’re often called “junk,” but they’re generally not worthless. To compensate for the higher risks, they often promise higher yields. They’re often called “high-yield” bonds, held by more speculative investors and high-yield bond funds.¹

Moody's Rating	S&P Rating	Rating Description for Category
Investment Grade
Aaa	AAA	Considered the highest quality
Aa	AA	Considered high quality by all standards
A	A	A Considered upper-medium-grade obligations
Baa	BBB	Considered medium-grade obligations
Speculative Grade
Ba	BB	Considered to have speculative elements
B	B	Default vulnerability greater than higher-rated issues
Caa	CCC	Considered to be in poor standing
Ca	CC	Highly speculative
C	C	Lowest rated class of bonds
Default
D	D	In Default

After a rating downgrade, the market prices of bonds generally drop, reflecting the increased risk that a bond might default. The downgrade occurs because the company’s financial position and ability to pay principal and interest, has weakened—at least in the eyes of the bond-rating agencies. The yield must rise to compensate a new investor purchasing the bond, based on the new, higher credit risks.

Many “junk” bonds start out with low ratings, and continue as “spec-grade” for their life without much change in credit position or price. Others can work their way downward from an investment-grade rating through a variety of scenarios, including bankruptcy.

We’ve listed some of these scenarios below, if you do own bonds that have been downgraded to “junk”:

Scenario 1: Rebound and recovery—or status quo
In contrast to the gloomy daily news, most “speculative-grade” bonds continue to make interest and principal payments on time and in full.

Annual default rates—meaning the default rate of any particular bond during any single year—have averaged around 4.5% from 1920 to 2007, rising to 10% or more during recessionary periods, according to Moody’s Investor Services.

The longer an investor holds a “spec-grade” bond, the greater the risk of default over time. During a 10-year period, the historical default rate on any single bond rated as junk rose to 27%. So junk bonds are not the best investment under any conditions if you’re relying on stable long-term coupon payments.

If the company continues to operate, bond payments would continue to be paid, and you’d receive 100% of the promised par amount at maturity.

Scenario 2: Government bailout or loan
Even though bailouts and government loans have been capturing headlines, the vast majority of issuers with junk bonds will never receive government support. For those that do, government funds can help prevent bankruptcy. But there may be strings attached, such as, in recent cases, the renegotiation of bond terms. For more information, see “Does Government Support Help or Hurt Bank Bonds?”

Scenario 3: Bond renegotiation or exchange
A bond is a legal contract between the issuer and the bondholder. Like any contract, it can be renegotiated, with the approval of both parties. An offer to renegotiate, or exchange bonds for new securities, can be a way to avoid bankruptcy while buying time and flexibility to reorganize or restructure.

Bondholders must weigh the trade-offs: Would they rather take some repayment now, including possibly a portion in stock, or risk bankruptcy? Also note, in recent cases (GMAC), retail bondholders are not always included. The company can choose particular borrowers with whom to renegotiate. Those not included may actually benefit, depending on the terms. A renegotiation often results in an exchange of existing bonds for less than the original principal amount, or an exchange for common stock.

Scenario 4: Chapter 11 bankruptcy or default
In situations of extreme distress, “junk” bond issuers proceed from trouble to insolvency to bankruptcy and default (or vice versa).²
Chapter 11 bankruptcy provides protection from creditors and time to reorganize. All contracts are frozen and restructured by the bankruptcy court. Debt payments are interrupted, and return of principal, if any, could be for less than the full dollar invested.

The price of bonds nearing bankruptcy generally reflects a market consensus on how much an investor might expect to eventually recovery of the original par amount. The lower the price, the lower the consensus on any recovery at all. In Chapter 11, the company hopes to keep operating after restructuring, so a bondholder may receive shares of common stock of a newly restructured company at a discount from the original par amount.

Scenario 5: Chapter 7 bankruptcy and liquidation
Chapter 7 bankruptcies are the last resort. They result in liquidation and use of the proceeds of any sale to pay off creditors, including bondholders, often at fire-sale prices.

Repayment of principal depends entirely on the assets available, sale price, and creditor’s seniority in the line of payment.

The order of debt repayment usually will be:

State, local and federal taxes.
Financial institutions including bank loans.
Other creditors including suppliers and employees.
Bondholders, in order of seniority—senior secured, senior unsecured, junior unsecured.
Preferred shareholders.
Common shareholders.

Senior, or secured, bondholders can receive a portion of their initial investment. More junior, or unsecured, bondholders typically receive less (if anything at all). Common stockholders often receive nothing.

If you're holding junk bonds, what should you consider?
Given all of these scenarios, how should an individual investor make an informed investment decision? Ask yourself the following questions:

Do you value certainty of income most highly?
Do you want income, but can take some risk given what might be an undervalued bond price?
Or are you an optimist, thinking conditions will improve, or that the value of your bond has dropped so far in value that holding is like a lottery ticket (or sunk cost)?

Depending on your strategy and the importance of steady income, we believe that you should consider holding (CH), selling (CS), or make a decision to hold or sell based primarily on the current price or offered terms (DT).

Investor type and ultimate decision

	(A) Rely on income	(B) Income important but can take some risk	(C) Optimist (or sunk cost)
Scenario 1: Rebound and recovery	CH	CH	CH
Scenario 2: Government bailout or loan	DT	CH	CH
Scenario 3: Renegotiation or exchange	DT	CH	CH
Scenario 4: Chapter 11 bankruptcy or default	CS	DT	CH
Scenario 5: Chapter 7 bankruptcy and liquidation	CS	CS	DT

Note: CH = consider holding, CS = consider selling, DT = depends on terms.

The investor who relies on bonds for income
Your decision to hold or sell depends on how much you need the income and how much risk you’re willing to take that coupon payment will continue.

Be prepared: A “spec-grade” bond that goes into default could stop generating income for several years, and would likely drop even more dramatically in price should you really need to sell.

You might also consider maturity:

The longer the maturity, the longer you'll have to depend on the company to pay. Longer-term bonds tend to drop more in price when credit weakens, for the same reason.
The shorter the maturity, the less you’ll have to rely on the health of the company, and reliable interest payments, over the longer term

Unfortunately—and this may seem painfully obvious to the investor stuck with a “problem” bond investment—there may be no easy decision. If you do rely on bonds for income, the best general guideline may be to sell at the first sign of problems. Of course, as we all know, that hasn’t always been easy.

If you choose to sell, a sale can fit into an overall tax-reduction strategy. To see examples, read our related articles, “Harvesting Losses on Mutual Funds” and “Get a Tax Break by Harvesting Losses.”

The more flexible long-term investor
If a company is able to continue operating (even in a weakened position), you’ll continue to benefit from coupon payments and repayment of principal at maturity.

If you are willing to take some risk, especially if prices are well below your original purchase price, you might just consider holding the bonds and hope for continued income with that heightened risk attached. Remember that the current bond price is only important if you choose to sell.

Some additional thoughts to keep in mind:

We believe that the market for both investment- and speculative-grade debt may have overreacted to fear about credit risk of any kind. Over time, we expect that these conditions should stabilize and move back toward more "normal" levels. If so, the price of junk bonds (short of default), should continue to improve.
Bond default rates have tended to rise during a recession and peak toward the end, falling sharply thereafter. In the current recession, financial sector defaults (dominated by Lehman Brothers and Washington Mutual) have led the way—another argument for diversification by sector, as well as security.
However, defaults by nonfinancial borrowers (somewhat ominously) appear to be lagging. Will those defaults continue to increase? Some experts think so. As such, nonfinancial sector bonds may be worth watching, as well.

The optimist
Recently, many speculative-grade bonds have been trading at pennies on the dollar, well below the price that some experts think might eventually be repaid (depending, of course, on the individual company and bond security)

While a stock’s price can ultimately reach zero, bondholders have some additional guarantees compared to stockholders, including the possibility (at least on senior bonds) of recouping some of their initial investment.

If you have the time to wait, a high risk tolerance and no need for a predictable income stream, then waiting out the current volatility might be preferable to selling now at a steep loss from your original investment.

As always, if you have questions or need help, please contact your Schwab consultant. To speak with a Fixed Income Specialist, call 800-626-4600.

Important Disclosures

1. We generally recommend that individual investors only invest in “junk” bonds through a diversified high yield bond fund, and generally as only a small part, if any, of their total fixed income portfolio.

2. According rating agency data, roughly 60% of issuers defaulted first and then filed for bankruptcy, while the remainder directly entered bankruptcy and then stopped paying on bonds.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Past results are not indicative of future performance.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity.

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