This article seeks to help readers better navigate the world of junk bonds. Serving as the most risk-laden form of bonds, they provide investors higher yields which draws investors in. Read on for a more thorough understanding of the same.
Defining Junk Bonds
Also known as high-yield bonds, junk bonds definition can be understood to be those bonds that fall below investment grade made clear by the three large bond rating agencies i.e., Moody’s Standard & Poor’s, and Fitch. Junk bonds are characteristic of having a higher risk of default in comparison to other bonds. What makes them popular among investors, however, is the fact that they pay potentially higher returns. The primary issuers of junk bonds include companies that are capital intensive and have high debt ratios as well as companies that are starting out and have yet to establish for themselves a strong credit rating.
Bonds operate by virtue of buyers lending money to issuers in lieu of periodic payments of interest. Upon the bond attaining maturity, the issuer is required to pay back the principal in its entirety to investors. However, should the issuer in question operate with a high level of risk in terms of default, the interest payments owed may not be provided in accordance with the scheduled time frame. In such scenarios, the bonds provide higher yields in order to offset those who invested in the same owing to the additional risk involved.
Market analysts may in fact make use of the junk bond market in order to understand where the economy presently stands. Should more investors be amenable to buying junk bonds, their willingness to incur risk highlights an optimistic outlook towards the economy. On the other hand, should investors shirk away from junk bonds, it indicates their risk-averse nature which means they have a pessimistic outlook towards the way the economy presently stands. This can further be used to indicate either a contraction within a business cycle or the presence of a bear market.
Understanding how Junk Bonds are Rated
Those who issue bonds are each given credit ratings based on their likelihood of fulfilling or defaulting on their financial obligations. As mentioned above, this credit rating is set forth by three prevailing rating agencies.
Bonds that are issued high credit ratings are viewed as investment-grade and are flocked to most frequently by investors. Conversely, bonds that are dealt with low credit ratings are viewed as non-investment grade or called junk bonds. Owing to the fact that they have a greater risk of default involved, they ordinarily pay 4 to 6 points higher interest rates in comparison to investment-grade bonds.
Keeping in mind the ratings of the aforementioned large rating agencies, junk bonds are given a “Baa” rating or lower from Moody’s and a “BBB” rating or lower from Standard & Poor’s. A “C” rating indicates a higher rate of default by the bond issuer in question whereas a rating of “D” is indicative of the bond being in default. Ordinarily, investors avail of junk bonds via mutual funds or via exchange-traded bonds. Mutual funds are able to offset the risks associated with investing in junk bonds by providing their investors with a bond portfolio that is inherently diversified. When considering non-investment grade bonds, their returns fluctuate over vast time frames keeping in mind their issuers and in accordance with the overarching state of the economy.
Examining the Pros and Cons of Investing in Junk Bonds
Junk bonds provide their investors with both advantages as well as disadvantages which have each been examined below.
Pros of Junk Bonds
When pitted against other fixed-income investments, junk bond investments provide their investors with potentially higher rates of return.
Owing to the fact that they are ordinarily issued with 10-year terms, these high yield bonds have the potential to improve should the issuer’s credit rating improve prior to the junk bond maturing. In the event that this does in fact happen, then the value of the bond surges upward and allows for holders of junk bonds to avail of greater returns.
Should a company that issues junk bonds decide to liquidate, holders of junk bonds are given precedence over stockholders. This allows junk bondholders to gain an advantage such that they can at least recover a portion of their investment should the company default.
They can be used to serve as risk indicators that highlight when investors are amenable to taking risks or avoiding risks in the market.
Cons of Junk Bonds
In comparison to other bonds, junk bonds have the greatest likelihood of defaulting.
Should a company default, those that hold junk bonds are capable of losing their investments in their entirety i.e., 100 percent.
Further, if a company’s credit rating sinks below where it presently stands, the value that their bonds hold falls.
Next, when considering the interest rate on investment-grade bonds, should the same increase, they are viewed in a less attractive light by investors.
Recessions, however, are capable of inflicting the most damage on junk bonds as investors then frequent more conservative investments that serve as safer bets.
The prices of junk bonds are known for their volatile nature owing to the uncertainty that surrounds their issuer’s financial performance.
Active junk bond markets are capable of showcasing a market that is overbought i.e., one which features investors that have too complacent an attitude towards risk which is capable of leading to market downturns.
Junk bonds are affected by improving financials i.e., should the company issuing junk bonds perform well, its bonds will reflect improved credit ratings which will pique the interest of investors. This can cause the bond’s price to rise as investors will be more amenable to paying for the bond that is a financially viable investment. However, companies that perform poorly might witness a decline in their credit ratings which can deter investors. Bond investors are known to monitor the credit ratings associated with bonds such that they can make prudent investment decisions.