Junk Bonds Pros And Cons – What are Junk bonds? | Example Analysis
What are junk bonds? The term, junk bonds, is seen in a negative way. While junk bonds are considered risky investments, they may not be as bad as the negative reputation suggests. Let’s take a look at junk bonds, their pros, and their cons.
Junk bonds are bonds issued by companies that are not in a good financial state and, therefore, have a high risk of delayed payment or defaulting — not paying their interest payments or repaying the principal to investors. The major pro of junk bonds is higher yield than investment-grade bonds, while the main con is the high risk of default.
In this post, we will take a look at the following:
- What are junk bonds?
- How does a junk bond work?
- What are the two types of junk bonds?
- Are junk bonds worth it?
- Junk bonds example
- Junk bonds rating
- Junk bonds and interest rates
- Junk bonds advantages and disadvantages
- How to buy junk bonds
Before we start, we remind you that we have a few bond trading strategies: bond trading strategies.
What is meant by a junk bond?
A junk bond is a bond that carries a higher risk of default than most other government and corporation-issued bonds. As you know, bonds are debt instruments with which an issuer agrees to pay investors interest payments along with the return of invested principal at a specified future date.
Junk bonds are bonds issued by companies that are not in a good financial state and, therefore, have a high risk of delayed payment or defaulting — not paying their interest payments or repaying the principal to investors. So, they are corporate bonds that do not have an investment-grade credit rating.
Most times, junk bonds are called high-yield bonds because the interest payments are higher than for the average corporate bond. Most people use both terms junk bonds and high-yield bonds interchangeably.
Junk bonds may carry the highest risk of a company missing an interest payment (default risk), but they are still are less likely than many stocks to generate permanent portfolio losses since a company is obligated to repay bondholders before shareholders if it goes bankrupt. However, since companies that issue high-yield bonds have credit ratings below what is considered “investment-grade” by at least one of three rating agencies — Moody’s, Standard & Poor’s, and Fitch — these companies pay high interest rates to entice investors to take on the higher risk of lending them money.
How does a junk bond work?
Understanding a junk bond works is simple: it is debt that has been given a low credit rating (below investment grade) by a rating agency because they are riskier, as the chances that the issuer will default or experience a credit event are higher. Given the higher risk, investors are compensated with higher interest rates, which is why junk bonds are also called high-yield bonds.
But technically, a junk bond is very similar to regular corporate bonds, as both represent debt issued by a firm with the promise to pay interest and to return the principal at maturity. However, junk bonds differ because of their issuers’ poorer credit quality.
Let’s look at the basics: bonds are fixed-income debt instruments issued by corporations and governments to raise capital. Investors buying binds are effectively loaning money to the issuer who promises to repay the money on a specific date called the maturity date while paying interests on a regular interval (mostly annually). At maturity, the investors are repaid the principal amount invested. This is the same with junk bonds, except that there is a higher risk of default and consequently, investors are offered higher interests to compensate for that.
Here is a junk bonds example: a startup named XYZ issues a five-year bond with a 12% annual coupon rate at $1,000 per unit. However, the company’s bond has a Fitch rating of BB. This means that the bond has a high risk of default, given the company’s startup status and financial history. However, an investor who purchases the bond earns an amazing 12% per year. So, with a $1,000 face—or par—value, the investor will receive 12% x $1,000 ($120 per unit purchased) each year until the bond matures.
What are the two types of junk bonds?
Companies with junk bonds usually have a credit rating of BB or lower by S&P or Fitch, or Ba or lower by Moody’s. Such corporate bonds are often classified into two sub-categories:
Fallen Angels: These are from companies that were once investment grade but have since been reduced to non-investment bond status because of their current financial status. Thus, a fallen angel bond is debt originally issued by an investment-grade company that has since been downgraded to “junk” status by a credit rating agency. The reason for downgrading it could be that the business is losing money, issues too much debt, or operates in an industry in secular decline.
Rising Stars: These are from companies that are just starting out and may not be in good financial standing. They are growth companies that are looking for funds to expand their projects and may not be profitable at that time. These companies may, at the moment, not be rated investment grade, but their ratings may rise in the future.
Are junk bonds worth it?
Junk bonds are not intrinsically good or bad investments; it depends on the individual bond and the investor’s appetite for risk