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Do Junk Bonds Yield Pain Or Pleasure?

|About: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), Includes: JNK

Let's face it, investing can often be a dull, tedious activity full of snooze-inducing terminology. Then there are junk bonds, optimistically referred to by the people who sell them as "high-yield bonds." If U.S. Treasury bonds are Tylenol, junk bonds are the Vicodin you stole from your mom's dresser. To put it simply, junk bonds are the riskiest debt that's easily purchased-issued by companies that have taken a turn for the worse and for whom the threat of default (not paying their debts) is very real. But just like narcotics, the danger comes with a tempting thrill: much, much higher interest rates that you, the lender (bond owner), receive from these desperate corporations. Sounds like a gamble, but we'll show you how and why even conservative investors often include a manageable dose of these risky securities.

Junk bonds defined

What exactly are junk bonds? Technically, they're just like any other corporate bond-issued by a company that wants to borrow money from the public, with regular interest payments and a maturity date when lenders get their principal back. Where junk bonds differ is in their relative risk, usually determined by the major credit rating agencies such as Moody's, Standard & Poor's and Fitch. These firms slap ratings on nearly all debt issued to public investors and while there are many ratings in their scale, most debt falls into one of two groups: investment grade and junk.

Investment grade ranges from the highest rating, AAA, to BBB. These bonds carry a very low risk of default and sometimes don't pay much more in interest than the U.S. government (despite the fact that only Uncle Sam, and not GE (NYSE:GE) or IBM (NYSE:IBM), can print dollars!). These highly-rated bonds are called "investment grade" because most corporate bonds are owned by institutions-typically insurance companies, pensions, banks and mutual funds-that are restricted in what they can own. Insurers, for example, often can only own investment grade debt to limit the risk to shareholders and policyholders. Anything rated below BBB is considered junk, or high-yield, and until a few decades ago few people wanted to own it, and even fewer would buy bonds rated junk from the time they were issued.

Why people buy junk bonds: yield

Calling junk "high-yield bonds" isn't a misnomer. To compensate lenders (aka investors) for the added risk of not getting their money back, junk bonds pay higher rates of interest. In the bond market, that's known as "yield." A new bond might come with a 3% interest rate but if the company runs into financial problems, the price of its bonds will fall so an investor buying after the problems started would spend less money to get the same interest payments, which are fixed. That means the yield on the bond, what you get for every $100 invested, goes up. One way to measure yield is the "spread," or difference, between types of bonds. Historically, the spread between junk and Treasuries, which are considered risk free, has hovered between 4% and 6%. That is, if a 10-year Treasury bond is yielding 3% today, a 10-year junk bond might yield 7%.

Since the financial crisis, interest rates have been at historic lows. This leaves investors looking for higher yields elsewhere and one place to look is in junk. Today spreads are above their historical averages and some analysts and investors see buying junk bonds as a smart move. Corporate balance sheets are relatively healthy as companies are generating cash and sustaining strong margins despite the downturn, they say. And as Treasury yields sink lower and lower and the Federal Reserve promises to keep rates low for a while, the additional reward provided by junk investments seems increasingly attractive.

Naysayers have been wary of junk since this past summer, when markets tumbled. Unlike ultra-safe bonds, many high-yield bonds act more like stocks than debt instruments. That's because their value is more closely linked with the fortunes of the borrower-if the company survives you'll be paid back, if it fails you'll lose most of your investment. Junk bonds do follow boom and bust cycles as stocks do, so times of global market turmoil can spoil the attractiveness of higher-yield securities.

If all of this has merely whet your appetite for junk bonds, consider that buying them for an individual portfolio is not for the poor or the busy: corporate bonds often must be purchased in denominations of $10,000 or more and each bond carries with it a long set of covenants and features that you'd need a lawyer to help decode. To create a diversified portfolio you'd need several hundred thousand dollars and lots of time to do research. Fortunately, there's a much easier way to get exposure to junk: via low-cost, diversified exchange-traded funds (ETFs). The iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG) or the SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) cost just 0.5% and 0.4% a year, respectively.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.