Previous

Page - 9

The Dilemma - Risk-Return Tradeoff

The riskiest of all bonds are high-yielding corporate obligations commonly known as junk bonds. These bonds are exceedingly vulnerable to default. They are highly speculative securities. Junk bonds are debt securities of issuers with limited credit standing.
In other words, the corporations that issue these bonds have either no credit history because they are relatively new, or a credit history with serious problems of one sort or another.

Junk bonds return about 5 percent to 7 percent more than long-term treasuries. This ratio is often regarded as a key to whether the bonds are under priced or overpriced in relation to the market. In a period of uncertainty, investors’ "flight to quality" pushes the spread between junk bonds and treasuries even further as junk prices drop and yields rise - the opposite of what happen to treasury securities.

Tax Benefits

Another advantage of junk bonds is that since junk bonds are taxable investments and are expected to provide more income, they will naturally be subject to higher taxes. However, in a tax-advantaged account, they look spectacular: For someone in a 28 percent tax bracket, a 15 percent bond will produce an untaxed 20.8 percent. Taxes will have to be paid when the proceeds are withdrawn but then presumably at a lower tax rate.

Next

* Contributed by -
Ankit Chetan & Sudhanshu Duggal,
National Institute of Industrial Engineering (NITIE),
Mumbai.