Junk bonds are risky corporate bonds that can deliver high returns. Some investors avoid them, while some see an opportunity to profit from them, despite the elevated risk.
Junk Bonds Explained
In a nutshell, junk bonds are low-rated, speculative-grade bonds carrying a significant risk of the issuing companies missing payments (i.e., default risk) but have high-interest payment potential.
Also known as corporate bonds, these bonds are usually issued by companies that lack investment-grade credit ratings. Junk bond issuers pay high-interest rates to lead investors into taking more risk in lending them money.
When you buy bonds, you’re lending money to the bond issuer, which can be a government entity or a company. The issuer then promises to pay you back with interest once the bonds reach maturity. However, not every firm can guarantee that.
That is why there are bond ratings in place. They are letter grades provided by bond rating agencies, such as Standard & Poor’s, Moody’s, and Fitch. Junk bonds have a credit rating of BB and below with Standard & Poor’s and Fitch, while Moody’s rate junk bonds at Ba and below.
The Reason Why Investors Buy Junk Bonds
While junk bonds carry the highest default risk out of all bonds, investors would bet on them mainly because of their potential returns.
Junk bonds can earn more than investment-grade corporate bonds and bonds issued by government entities, as these two have lower rates of interest since they are less risky for investors.
On the other hand, junk bonds need to look more appealing to entice investors to take a more significant risk with their money, which is worth it over time for some investors.
Considering the default risk, junk bonds still have a lower chance than most stocks of leaving permanent damage on investors’ portfolios, as the issuing companies are required to pay back bondholders before their shareholders in the event of bankruptcy.
Benefits of Junk Bonds
Potential Returns
Junk bonds’ riskier nature often provide them a higher yield, raising their potential to deliver more returns than investment-grade bonds.
Future Appreciation
A junk bond can appreciate in value as the rating of its issuing company goes up. That means the issuing company needs to improve its performance and be active in paying down its debt, among others.
Less Risky than Individual Stocks
Indeed, junk bonds are riskier than investment-grade corporate bonds, but they may carry less risk than individual stocks. For example, if a company declares bankruptcy, bondholders and creditors are first in line to receive payment, while the stockholders are the last to get paid.
Factors to Consider Before Buying Junk Bonds
Default Risk
Junk bonds carry a significantly higher risk of a company defaulting on an interest payment. The default rate for junk bonds currently stands at 7%, while the default rate for investment-grade bonds stands within the 0%-1.02% range, depending on their credit rating.
Liquidity
Junk bonds can sometimes lack liquidity, making them tough to sell for cash when you need it.
Value
The worth of junk bonds can decline as their credit rating fall. As the company’s credit rating continues to fall, the bond will also decrease in value.
