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