A Quick and Dirty Way to Compare Investment Grade and Junk BondsAugust 8th, 2012 by Marc Prosser
Junk bonds pay a higher yield than investment grade bonds, primarily because they have a higher risk of default. However, the question of whether junk bonds will earn you a higher return comes down to their default rates, and the recovery rate after a bond defaults. (You can read about what happens after a bond defaults here.)
Here are the formulas:
Return On Investment (ROI) Investment Grade Bonds^ = Investment Grade Yield^^ – (Annual Default Rate x (1 – Recovery Rate)
Returns On Investment (ROI) Junk Bonds^= Junk Bond Yield^^ – (Annual Default Rate x (1 – Recovery Rate))
^Assumes Bonds Are Held To Maturity
^^ In the chart for the article, “Junk bonds Are A Screaming Buy”, the OAS spread is substituted for Yield. That will lower the ROI by the amount of the treasury spread but as you are using OAS spreads for both its a fair comparison.
Investment grade corporate bonds have a tiny default rate. Only twice in the last 14 years (2002 and 2008) has the default rate for investment grade bonds reached over 0.5%. Even then, the rate did not rise above 0.75%.
To make things simple (quick and dirty) and make the case that junk bonds are a better investment than investment grade bonds as difficult as possible, we will tilt the odds in favor of investment grade bonds by calling the default rate for investment grade bonds zero. We will also ignore the fact that many investment grade bonds over a period of time become rated as junk, and then default.
Typically, corporate bond holders have are a recovery rate (the percentage of debt and interest owed to the bondholder that is returned following a default) of around 40%, however the exact percentage varies from company to company, and industry to industry. However, again to keep things simple and make the case for junk bonds as difficult as possible, we are going to assume that the recovery rate, is zero.
After these assumptions, you can reduce the above formulas to the following:
ROI Investment Grade Bonds = Yield On Investment Grade Bonds
ROI Junk Bonds = Yield on Investment – Annual Default Rate