Finance

Junk Bonds

Junk Bonds

Junk bonds, also known as high-yield bonds, are corporate bonds that are high-risk and might even probably deliver high returns. Since the company which issues these bonds is financially unstable, the credit rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings, graded them as non-investment grades.

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What are Junk Bonds?

Junk Bonds are bonds that carry a higher risk of default than most of the bonds issued by corporates or governments. A bond is an obligation to pay investors interest and the invested principal in exchange for bonds. Junk Bonds are bonds issued by organizations that are struggling financially and have a high danger of defaulting or not paying interest amount or repaying the principal to investors. Compared to other bonds, these bonds tend to have the highest return to compensate for the added risk, which is why they are considered high-yield bonds.

How to invest in them?

For a retail investor, the most ideal approach to invest in junk bonds is the same as it is for investment-grade bonds. This works for two fundamental reasons.

  • To start with, it eliminates complexity. Not many individual investors have the resources to purchase corporate bonds on the primary market i.e. buying directly from the company. While the secondary market is a suitable alternative, but one requires a serious level of aptitude and resources to use effectively.
  • Second, purchasing bonds through mutual funds and ETFs permits you to spread your risk over numerous resources. In the junk bond market, this is particularly significant. Given the moderately high rate of default among holdings in junk bonds, a packaged portfolio can permit you to catch their profits.

Advantages:

There are numerous advantages of junk bonds that can be attractive to investors:

  • They offer a higher-payout as compared to traditional investment-grade bonds.
  • If the company that issues the bonds improves their credit rating, the bond may appreciate it as well.
  • Bondholders get paid out before stockholders when the company falls.
  • Recession-resistant companies may be underrated.
  • More dependable ROI than stocks.

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Disadvantages:

  • Higher default rates.
  • They are not as fluid as investment-grade bonds.
  • High-yield corporate bonds are the first to go during a recession.
  • The value/price of a high yield corporate bond can be affected by changes in the interest rates.
  • The value/price of a high yield corporate bond is also affected by a drop in the issuer’s credit rating.

Example:

Tesla Inc. (TSLA) issued a fixed-rate bond with a maturity date of March 1, 2021, and a fixed semi-annual coupon rate of 1.25%. The debt received an S&P rating of B- in 2014 when it was issued. In Oct 2020, S&P upgraded its rating to BB- from B+. This is still in junk bond rating territory. A BB rating from S&P means the rating issue is less vulnerable to nonpayment, but still faces major uncertainties or exposure to adverse business or economic conditions.

Bottom Line:

Yes, junk bonds are more volatile and therefore, riskier than investment-grade and government-grade bonds but they also have advantages when analyzed in detail. It totally depends on the investor’s risk appetite. It helps protect a portfolio when the economy is weakening.

 

Author – Priyanshu Ahuja

About the author – I’m a first-year student from City Premier College, Nagpur, pursuing BBA. My interest includes financial markets and the investment domain.

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