Junk bonds are common bonds issued with high-risk ratings by credit rating agencies. These bonds carry a higher risk of default than other bonds. A higher risk of default means a higher yield on investment; hence these bonds are also called high-yield bonds.
These bonds work similarly to any other commercial bond. Bond issuers of junk bonds are either financially struggling companies or with poor credit ratings. Either way, the poor rating on an issued bond makes it a junk bond.
Deeper Definition
Bonds are debt instruments. Top credit rating agencies like S&P’s, Moody’s, and Fitch rating issue ratings for every bond. The credit rating for every bond depends on the bond issuer’s financial stature. Bonds issued with poor credit ratings are called junk bonds.
These bonds are issued by companies with a higher risk of default. These bonds are listed below investment categories by the top credit rating agencies. Since investors face a higher risk of default, they demand higher returns on investment. These bond issuers also offer a discount on the face value of the bond and higher rates of return to attract investors.
These bonds are also used by government institutes and corporations as market indicator tools. If investors are willing to take risks on these bonds, it indicates a positive signal on economic conditions. Contrarily, if investors do not show faith in junk bonds, it means worse economic conditions and speculative market conditions.
How Does a Junk Bond Work?
Bond issuers issue bonds to raise capital financing from the market. Issuers would need to make periodic interest payments and repay the principal at maturity. Some bond issuers face a financial crunch hence face poor credit ratings. Bonds issued by these companies are labeled as junk bonds.
Top credit rating agencies like S&P’s and Moody’s categorize bonds into two broader categories. Low-risk to medium-risk bonds are called investment bonds. These bonds are rated AAA to BBB. These bonds carry low default risk and are preferred investment instruments for many investors seeking safe returns. High-risk bonds are rated BB or below. These bonds carry a higher risk of default.
Investors are willing to take risks on these bonds in anticipation of higher returns. Some investors anticipate good financial performance from bond issuers in the future that can improve a junk bond’s rating. The improved rating would improve its face value hence improving return on investment.
Institutional investors and wealthy investors are the investors in these bonds. These investors seek help from financial advisors to pick the right type of junk bonds. Although every junk bond carries high default risk, not all bonds perform poorly. Bonds are issued with long-term maturity; hence investors anticipate good financial performance over time by the bond issuer.
Special Considerations with Junk Bonds
Investors in bonds monitor credit ratings issued by top credit rating agencies. These bonds are indicators of default risk.
Broader categories for bond ratings are:
- AAA – Excellent rating
- AA- Very Good
- A – Good
- BBB – Adequate
Speculative or riskier bond ratings include:
- BB- Junk category
- CCC- vulnerable to default
- CC- high default risk
- C- in Default
The good financial performance of the bond issuer can improve the bond rating over time. Many investors seek high-risk investments in these bonds in anticipation of good financial performance by the issuer. Contrarily, if the financial performance of the bond issuer further falls, credit rating agencies will downgrade the bond ratings.
If any bond misses an interest payment or principal repayment, it is considered in default. These bonds carry high default risk anyway. Investors seek high yield on riskier investments. Hence, junk bond issuers offer deep discounts on face value as well as high-interest rates to attract investors.
Advantages of Junk Bonds
Although these bonds carry high default risk but offer some advantages to investors and issuers as well.
- These bonds help companies in financial distress to raise capital financing.
- Investors receive a high return on investment as compared to other bonds.
- These bonds can improve face value if the issuer improves financial performance.
- Corporations and large companies issue these bonds to assess market conditions as well.
Disadvantages of Junk Bonds
Junk bonds come with several disadvantages as well:
- These bonds carry a high risk of default and investors can lose 100% of their investment.
- Often junk bond issuer’s credit rating further deteriorates that implies the value of the junk bond falls further.
- These bonds show volatility due to the unstable financial performance of the bond issuer.
Conclusion
Junk bonds come with a high risk of default due to poor credit ratings. These bonds are riskier investments hence call for a high return on investment. However, if the issuer improves financial performance, junk bonds can improve ratings. Investors looking for high yield with high-risk investments use junk bonds.
