Junk Bond - Explained
What is a Junk Bond?
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Table of ContentsWhat is a Junk Bond?How Does a Junk Bond Work?Rating the Junk BondJunk Bond GradingJunk Bonds as a Market IndicatorThe Pros and Cons of a Junk BondThe Bottom Line
What is a Junk Bond?
Junk bond refers to bonds that have the highest risk of default than those bonds that the governments and corporation issues. Note that a relationship is a debt where investors receive the interest payment, including the return of the principal they have invested in exchange for a bond purchase. Bonds are mostly issued to those companies with financial problems, and there are high chances that they will not pay back the principal or interest payment to investors.
How Does a Junk Bond Work?
When you purchase a bond, it means that you are loaning your money to a business entity or government, which in turn promises to repay the money when the bond matures, including the interest. The credit rating reflects the ability of the bond issuer to meet its obligation. So, to know whether or not a business entity defaults, it will highly depend on its ability to service the debt. Note that it is the credit rating system that determines the default risk of a particular company. Default risk refers to the chance that a firm or government will delay repayment or will not be able to meet the payment obligation at all when the bond reaches maturity. Such defaults on bond happen within the first or so years after the issuing of the bonds.
Rating the Junk Bond
Investors indeed consider junk bond investment to be a risky venture. However, it is easy for them to monitor the risk level of the bond by looking at the credit rating of the bonds. A credit rating refers to a creditworthiness assessment of the issuer and the unsettled debt that is in the form of bonds. Note that the credit rating of a company and bonds does impact the bonds market price and its interest rates. Credit-rating agencies work is to assess the creditworthiness of government and corporate bonds so that investors can have correct insights about the debt securities risks. In most cases, the credit rating agencies usually assign grades in the form of letters to help investors view the issue.
Junk Bond Grading
To measure a credit rating of a bond, investment analysts use a grading system that begins with a AAA rating for bonds with low chances of defaulting moving down to C and D, where chances of defaulting are high. The junk bonds rating is BB or lower. It means that it carries a more moderate rating making it speculative-grade. If this happens to be the case, then those high-risk investors should consider this to be a red flag. Bonds with an investment-grade rating come from companies with a high probability of meeting the payment obligations of regular coupons and giving back the principal to investors. The standard ratings are as below:
- AAA- Excellent
- AA- Perfect
- A- Good
- BBB- Adequate
Note that the moment the rating of a bond goes down into the BB category, it falls into the territory of junk bond. It is an area that scares investors the most because there is a high risk of default. In other words, there are high chances of them making a total loss on their investments as they can lose both the interest and principal amount. The following represents some of the speculative ratings:
- CCC- currently vulnerable to nonpayment
- C- Highly vulnerable to nonpayment
- D- In default
Note that companies with bonds that have low credit ratings may find it hard to raise capital to fund their current business operations. However, if a company can improve the credit rating of its bond and financial performance, then a substantial appreciation of a bonds price will occur. On the other hand, if the financial situation of a company drops, then the firms credit rating, as well as its bond, is likely to be reduced by the agencies that rate credits. It is, therefore, crucial that investors who plan to venture into junk bond investment to do thorough research first. They need to do an in-depth investigation of the business, including all their financial documents before buying the bond. Bonds with high credit ratings are also called investment-grade bonds, while those with a likelihood of default are known as non-investment grade or speculative. Firms may issue low-grade bonds without questionable ability to pay back the money. The reason is that the majority of brokers avoid investing in these low-grade bonds, also known as junk bonds. However, since this type of bond has very high return rates, it is also known as high-yield bonds.
Junk Bonds as a Market Indicator
When investors purchase junk bonds, is because they expect to profit from potential improvement in a company's financial performance rather than the return of interest income. Also, investors who predict the possibility of bond price rising, usually bet that there is bound to be an increase in buying interest for high-yield bonds. And this includes those with lower rates because of a change in market risk investment. Junk bond market is an early indicator to investors of the level of risks they are ready to take. So, if investors happen to keep off junk bonds or get out of junk bonds, it means that they are not optimistic about economic growth and, therefore, become market averse. Such a situation predicts the presence of contraction in the business cycle. On the other hand, if investors happen to purchase the junk bond, then it is an indication that investors have confidence in economic growth and are ready to take more risks. It foretells that there will be an economic expansion or a market upturn. For example, lets assume that we have investors in the United States who believe that there is an improvement in the economic condition. In this case, there are high chances of these investors purchasing junk bonds, especially from companies that show improvement in their financial performance that is in line with economic growth. On the other hand, if junk bonds are selling off with the fall in prices, then it means that the investors are more cautious with the risk involved. For this reason, they will go for a more stable and secure investment. It is crucial to keep in mind that junk bonds have price swings that are large compared to the others with higher quality. So, an investor who plans to buy a junk bond can purchase it as an individual via a broker. Better still, the individual can invest in a junk bond fund, which is under the management of a professional portfolio manager.
The Pros and Cons of a Junk Bond
Pros Junk bonds are capable of boosting your portfolios overall returns while it avoids stocks high volatility. What it does is that it offers higher returns when you compare it with investment-grade bonds. It also has a chance of performing better when there is an upgrade, especially where there business improvement. For this reason, there is not much correlation between junk bonds with other types. Another advantage is that apart from the correlation between junk bonds and stocks, they also issue a fixed interest payment. In case of bankruptcy, bondholders get paid before stockholders. Another advantage is that the issue of a junk bond is within a term of ten years or less. As an investor, you can also call after four to five years. Also, junk bonds perform better during the business cycles expansion phase. The reason is that there is a low chance of underlying companies to default when financial performance is excellent. In other words, an improved economy reduces risks related to junk bonds.
Cons In a business default, as an investor, you will suffer a 100% loss of your initial investment. It is, therefore, vital for you as an investor to do an in-depth analysis of every company before making an investment decision. In case you are targeting to invest in high-yield mutual funds, then the portfolio manager will analyze before buying the bonds. Another limitation of junk bonds is that creditworthy companies can also experience negative economic trends. They have the cash flow to service their debts at the current interest rates. However, some investors usually default on their bond payment. It is what causes a sharp rise in interest rates on all the bonds in their industry. However, they are not able to afford the higher rates during the refinancing period. Lastly, junk bonds are generally vulnerable when there is an increase in interest rates. When the yield curve becomes flat, it means that banks have become cautious in their lending. In this case, speculative companies are not able to issue new bonds or refinance the existing ones.
The Bottom Line
Generally, for informed investors, junk bonds are indeed a valuable investment. However, the expectation that they will bring in high returns comes with the possibility of high risk. That is why an in-depth analysis of the companies is necessary before making an investment move.