What Are Junk Bonds?

Oct 27, 2023 By Triston Martin

The risk of default on junk bonds, often known as "high-yield" bonds, is much greater than the risk of default on investment-grade corporate bonds. When looking through a list of possible bond investments, it is simple to identify junk bonds since they have received credit ratings of BB or worse from rating organizations such as S&P or Fitch or a rating of Ba or lower from Moody's.

When investing in junk bonds, it is a good idea to investigate the historical credit ratings of the underlying company issuing the bond. This will help you make a more informed decision. The bond may become a "Rising Star" on its road to becoming an investment-grade security if its credit rating improves. It may be a "Fallen Angel" that formerly had an investment-grade rating but has since been demoted because it has a credit score that is heading lower.

Junk Bond Credit Ratings

High Risk:

Moody's gave it a rating of Ba or B, while S&P gave it a BB or B. This indicates that the firm is now capable of meeting payments. Still, if economic or business circumstances deteriorate, it is very unlikely that it will be able to do so in the future. This is because it is exceptionally susceptible to being affected by unfavorable circumstances.

Highest Risk:

Moody's gave it a rating of Caa, Ca, or C; S&P gave it a rating of CCC, CC, or C. If the firm is to avoid going bankrupt, the business and economic climate must be on the company's side.

In Default:

Both Moody's and S&P have assigned it a grade of C.

Why Would Investors Choose to Invest in Junk Bonds?

As with any other investment or loan, taking on more risk will result in a higher interest rate. As an investor, this indicates that you have the potential to make a higher return on your investment when purchasing junk bonds as opposed to bonds with a lower level of risk. Your total returns from your portfolio may be improved by the addition of junk bonds while at the same time enabling you to avoid the greater volatility of equities. These bonds give yields greater than those offered by bonds rated investment grade, and they have the potential to perform even better if they are upgraded if the firm does improve.

The performance of junk bonds is often shown to be substantially associated with the performance of stocks and less closely correlated to the performance of other bonds. On the other hand, bonds come with predetermined interest payments, in contrast to stocks. In addition, they have a lower risk profile than stocks do in some respects. For instance, bondholders will often get payment before investors if a company files for bankruptcy.

A wide variety of maturities are available for junk bonds, ranging from four to over ten years, with ten being the most prevalent. A typical non-callable duration for junk bonds is from three to five years. This means the borrower cannot repay the bond before the end of the specified period.

Pros

  • Yields on investments that are more profitable for the investor are offered by high-yield bonds, which often have a greater interest rate than investment-grade bonds.
  • Bonds have a lower level of risk than equities do because, in the case of a firm going bankrupt, bondholders get their money back first.
  • Payments that are made regularly the standard junk bond, much like most corporate bonds, contains a "coupon" payment that is made regularly until the bond matures.

Cons

Increased likelihood of default Lower credit ratings indicates an increased likelihood of default or bankruptcy at the issuing firm, especially if the economy deteriorates.

Asset-price risk: If the bond's rating is downgraded, prospective purchasers will seek a higher yield, which will result in the market price of the bond falling.

How Do Investors Buy Junk Bonds?

  • Individual bonds if you have a sufficient amount of cash on hand, you may be able to open a brokerage account that will allow you to invest directly in individual bonds. On the other hand, a single bond does not provide very good diversification and is not the best choice for most investors.
  • ETFs, or exchange-traded funds, allow you exposure to many bonds at once and may be purchased and sold just like stocks. Before making a purchase, it is important to consider the fund's ratings, fees, and past performance.
  • Individual investors, often known as retail investors, have additional options in the form of bond mutual funds, which are mutual funds. Although they are purchased and sold in bulk during the nighttime hours, their operation is otherwise quite similar to that of ETFs.
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