Junk Bonds

JUNK BONDS

In order to properly understand the entire term and problematic regarding junk bonds, firstly in this paper we will do a short review of what bonds are, how they work and what are their main preferences.

1. Bonds

Bonds are securities that establish creditor relationship between two sides in the agreement, the purchaser (creditor) and the issuer (debtor). The issuer of the bond receives a certain agreed amount of money and in return obligates himself to repay the principal and certain level of interest until the end of a lifetime of a bond. Bonds require coupon or interest payments during or at the end of the lifetime of a bond and for this reason bonds are called fixed income securities. (Alon Brav, Campbell R. Harvey 1999)

The bond for which the purchaser pays fixed amount of money is called straight bond. The purchaser receives interest payments at regular periods. These payments are called coupon payments. Bonds most often pay a standard coupon amount and at the bond maturity the final interest payment is made plus the principal amount.

There are bonds that do not have coupon payments and these bonds are bought for less than their face value. This is called a discount on the bond and this kind of bond is also called zero coupon bond.

1.1 Types of bonds

Bonds can be issued by many different entities, including governments, corporations and different government agencies. In essence there are two main types of bonds according to the two major issuers of bonds. Those are government bonds like The United States Treasury bonds) and Corporate bonds like those of U.S. Corporations.

Government and treasuries issue three different kind of bonds:

- Treasury Bills or T-bills have maturities up to 12 months and they are in essence zero coupon bonds, so the only cash flow is the face value received at maturity.

- Treasury Notes have maturities between one and ten years. These bonds pay coupons twice per year with principal paid at full maturity, hence they are called straight bonds.

- Treasury Bonds are issued mostly for ten years or more, but can be issued at any maturity. They pay coupons every 6 months with principal paid at full maturity.

There are three major types of corporate bonds:

- Mortgage Bonds are bonds secured by real property, such as real estate or buildings. In cases of default this property can be sold for the repayment of the bond holders.

- Convertible Bonds are bonds that are exchanged for a stock in the corporation.

- Debentures are unsecured bonds that are backed only with the name and goodwill of the corporation that issues the bond. If the corporation is liquidated, holders