Junk Bonds: Higher Yield, Higher Risk

Junk Bonds: Higher Yield, Higher Risk

High-yield bonds, frequently referred to as junk bonds, are high-risk debt instruments rated below investment grade by the three major rating agencies, Moody's, Standard & Poor's, and Fitch.

The potential return on junk bonds is greater than that of investment-grade corporate bonds and federal government and other government agency bonds. Some investors are ready to fund firms with below-investment-grade credit and a greater likelihood of loan default because junk bonds offer higher rates of interest.

This article will discuss the characteristics, pros and cons, and applicability of junk bonds.

What Are Junk Bonds?

As a reminder, a bond is a financial instrument issued by a corporation or government organization that borrows money from the public for capital projects or other purposes – When an investor acquires a bond, they are essentially lending money to the entity selling or issuing the bond. The buyer, or lender, of the bond gets coupon payments on a periodic basis. At the end of the loan term, or maturity date, the bondholder gets repaid the principal amount.

The price at which a bond trades is impacted by the economic outlook, average market interest rates, and a company's financial performance. Bonds of riskier corporations tend to trade at discounts to face value, whilst bonds of lower-risk companies sell at premiums to face value.

In this context, junk bonds are commonly referred to as high-yield bonds since the interest payments are more than the ordinary corporate bond. These high interest rates are paid by companies that issue junk bonds to persuade investors to take on the increased risk of lending them money. Michael Milken, an American banker, established a market for junk bonds in the 1970s after seeing their unrealized market potential.

Additionally, the junk bond market is significant because some investors regard it as a measure of market risk and economic health. This is owing to the fact that if the economy shows indications of revival, investors will have a greater appetite for risk and buy more trash bonds. Alternatively, if investors believe the economy is slowing, they become more risk-averse and sell trash bonds in favor of safer assets.

Interest Rates of Junk Bonds

Similar to ordinary bonds, junk bonds pay a set interest rate, often semi-annually. This recurring, fixed interest payment is also known as a coupon payment. It is computed by multiplying the stated interest rate by the face value of the bond and dividing by the number of annual installments. The bond's last coupon payment and face value are paid to the bondholder upon maturity.

Figure 1: Junk bonds vs. 10-year treasury yield. Source: CMV
Figure 1: Junk bonds vs. 10-year treasury yield. Source: CMV

The coupon interest rate for an issuer is determined by its credit rating and the possibility of default. A bond is regarded to be in default when the issuer fails to repay either the principal or coupon. The greater the probability of default, the greater the risk, and hence the higher coupon interest to reward investors for taking on a greater degree of risk.

The Pros and Cons

Prior to making an investment, investors should be aware of the special dangers associated with junk bonds, notwithstanding their higher returns. Here are a few of the benefits and drawbacks of investing in junk bonds.

PROS

CONS

Greater rates of interest than investment-grade bonds.

Relatively high probability of overdue interest payment.

Comparatively less risk of incurring losses compared to stocks.

Greater price volatility than investment-grade bonds.

During times of market instability, less volatile than stock prices.

Exposed to partial or complete loss of value if the issuer files for bankruptcy.

Offer a consistent revenue stream at a compelling interest rate.

Mostly inappropriate for short-term investments.

Junk Bonds Examples

  • Ford formerly had investment-grade ratings but lost them in 2020 due to the global economic turmoil. Its junk bonds continue to trade at a premium, indicating the corporation's historical importance.
  • Tesla junk-rated debt is a product of its financial history, since the firm has only lately started to produce positive earnings growth. Consequently, the company is still making progress toward investment-grade rating.
  • The renowned bitcoin exchange Coinbase has issued $1.5 billion in junk bonds with maturities of seven and ten years. Eventually, the exchange was compelled to issue $2 billion in bonds due to excessive demand.

Junk Bond Funds

Investors who are interested in purchasing trash bonds but are unsure of which firms to invest in might begin by investing in a bad bond ETF or mutual fund. This may be an excellent method to have a professionally managed, diversified portfolio.

Indeed, a professional portfolio manager can traverse the complexities of bond investing and manage a bond portfolio with the correct timing of the market. For instance, a skilled bond manager who anticipates an economy's exit from a recession may invest more funds in the junk bond market in anticipation of improved economic circumstances.

Higher Yield for Higher Risk Investors

High-yield bonds might be a good option for investors with a high-risk tolerance and diverse portfolios. Which exact junk bonds are appropriate for investors relies on the amount of time they want to invest, the amount of income they wish to generate, as well as their risk tolerance. Thus, when selecting junk bonds, investors are advised to prioritize risk management above return maximization.

Additionally, as bonds are often only available in rather high batches, investors may want to consider investing in a high-yield bond index fund or high-yield bond mutual fund instead. Not only are shares of these funds more inexpensive, but they also invest in vast, diversified portfolios of high-yield bonds.

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