Meaning of Junk Bonds
Junk Bond refers to bonds providing a high rate of interest to investors but carries a higher risk of default on payment. It is also termed a speculative-grade bond with a high-yielding rate as interest payments are much higher than the average corporate bond. Junk bonds are rated below the investment grade by 3 big investment rating agencies, thereby denoting a large degree of risk. In order to attract investors, junk bonds pay high returns due to a larger risk of getting default than other bonds issued by governments and corporations. Such types of bonds are generally issued by capital-intensive firms having high debt ratios, or young companies that are yet to build a strong credit rating in the market.
However, Junk bonds in comparison to less risky or investment-grade bonds are generally not an ideal option for holding a long-term investment. It can cause investors to incur huge losses in the long run if proper due diligence is not taken. But junk bonds can provide good returns in the short run when market interest rates are lower and reliable investment avenues are providing poor returns. Junk bonds also serve as a good indication tool for identifying the state of the economy by market analysts. When more investors are buying junk bonds, their willingness to take risks shows optimism regarding the economy. Whereas, if investors are avoiding high-yield bonds that gives a sign of their risk-averse behavior, thereby indicating a pessimistic view of the economy’s state.
Advantages of Junk Bonds
The advantages of junk bonds are as explained below: –
- Junk bonds carry a higher potential for big profits: A high rate of return is one of the clearest benefits of junk bonds. These bonds are issued by companies not have investment-grade ratings and therefore they offer high ROI to attract investors. Due to their high-risky nature, the payout of junk bonds is much higher than similar-sized investment-grade bonds. This way it can be a great way to attain a high amount of returns in the fixed-income portfolio as compared to other types of offerings.
- Bonds get appreciated if an issuer improves: The value of a bond gets appreciated with the improvement in ratings of the issuer company. When the underlying company actively pays down its debt and enhances its level of performance, then the value of security also rises. So, if the investor is confident in the future about the rise of a particular company that has unfairly suffered from a negative credit rating, then he has identified an attractive investment.
- Bondholders are paid out before stockholders when a company fails: It is assumed by many peoples that bonds should be avoided as they become worthless in case the company goes bankrupt. But in reality, buying a high-yield bond is far safer than buying stock from the same company. Whenever a company gets defaults, all is not lost as bondholders are paid prior to stockholders in bank liquidation. In other words, it can be said that there is still a chance to recover something in case of company bankruptcy.
- Recession-resistant companies may be underrated: High-rated companies issuing corporate bonds are the first to get negatively hit at the time of recession. However, companies lacking investment-grade ratings on their bonds are recession-resistant as they boom during such times. This makes the companies issuing such types of bonds a safer option and perhaps more attractive at the time of economic slowdown.
Disadvantages of Junk Bonds
Various disadvantages of junk bonds are: –
- Junk Bonds have a high risk of default: Junk bonds typically carry a high risk of default as compared to investment-grade bonds. These are issued when the likelihood of getting default is much higher than that of similar companies. As default means losing out the entire value of the investment, therefore investors with risk-averse nature tend to avoid high-yield bonds.
- Not as fluid as investment-grade bonds: The high-yield bonds many times face liquidity issues making it difficult to sell them to cash by investors. Many investors hesitate to purchase high-yield bonds because of the traditional stigma attached to junk bonds. Therefore, high-yield bonds are not an attractive option for investors who want to ensure the freedom of reselling their bonds.
- Prices get affected by variations in credit ratings: The prices of junk bonds vary with the changes in credit ratings of the issuer’s company. Similar to the increase in bond prices with improvement in credit ratings, the price also gets drastically reduced when the credit ratings of the company deteriorate. Also, the bond becomes worthless, in case, if company rating gets dropped to much lower.
- The value may decline during the recession: The value/price of high-yield company bonds are the first to get negatively hit during the recession. Investors, at the time of recession, generally run for conservative options of investment such as cash, gold, or investment-grade bonds. High-yield bonds may not witness the same rise in value as they are already too risky and may even become riskier when the economy heads south.
Examples of Junk Bonds
There are few well-established companies having credit ratings below investment grade. Notable companies with credit ratings providing them a status of junk are: –
- Ford (NYSE: F)– Ford company was investment-graded in past but lost its grade ratings of investment in the year 2020 because of the coronavirus pandemic and collapse of the world economy. The junk bonds of the company are still trading at premiums that clearly show the legacy of the company.
- Tesla (NASDAQ: TSLA)– It is a newer and younger company in the market whose junk-rated debt is the outcome of its financial track record. The focus of the company on growth has enabled it to start producing positive free cash flow in recent times, although it is making great efforts toward becoming investment graded.