Fred has come up with what he thinks is a great way to make a high yield on his money. He’s planning on buying some junk bonds that are very low rated (B or lower) but are coming due pretty soon. Fred reasons that though the company may not be doing well, they’ll be ok long enough for him to collect his interest.
So Fred decides to invest in a bond issue of a company that originally raised $50 million. Because the bond is only rated CCC, he can earn 6% in just one year. And after all, what could go wrong? I mean it’s not like the company will have to suddenly come up with $50 million, er, wait a minute…
This is a strategy that I’ve heard suggested more than once recently. With rates so low, people are looking at short term very low rated junk bonds. The problem is, the very short term nature of those bonds may be a trap. Because when those bonds come due, the company has to pay them all off. And with a company already in financial distress, it could easily be the straw that breaks the camels back.
Any time you’re investing in a bond, for whatever period, you’re earning a relatively small sum. So don’t take a big risk like Fred is doing to earn another few percent. Make sure that the company can afford to pay you back, whenever your bond is coming due.