April 7

Junk bonds pros and cons – What is it?

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Last Updated on 7 April, 2022 by Samuelsson

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 is a junk bond?
  • How does a junk bond work?
  • What are the two types of junk bonds?
  • Are junk bonds worth it?
  • Junk bonds rating
  • Junk bonds and interest rates
  • Junk bonds advantages and disadvantages
  • How to buy junk bonds

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 and high returns. Some junk bonds may be an excellent option for investors seeking high returns. While junk bonds have a low credit rating, their higher yield compensates for the greater risk associated with a lower credit rating.

It’s important to know that just because a bond issuer is currently rated at lower than investment-grade counterparts doesn’t mean the bond will fail. Many junk corporate bonds do not fail to pay their interest and also return the principal at maturity. Moreover, when you consider that some of the companies behind these bonds are rising stars and may end up being more profitable than their investment-grade counterparts, you will understand why they can easily offer much higher returns.

But the situation varies from one bond issuer to another — not all junk bonds are the same. An investor must consider the specific circumstances of the company issuing them. Some junk bonds may be worth it for investors with a high risk appetite who desire high returns, it may not be suitable for risk-averse conservative investors.

Also, note that even though these bonds are considered riskier than other bonds, they may still be more stable than (not as volatile as) stocks. In other words, if you are looking for a risk level somewhere in the middle of a scale between the traditionally higher-risk stock market and the more stable lower-return, lower-risk bond market, junk bonds may be worth your bet.

Moreover, no stock or bond is guaranteed to bring returns without some form of risk, so it all comes down to choosing what you want to risk your money on. But don’t forget to investigate the bonds and weigh the pros and cons of each issuer against each other to determine whether or not a particular junk corporate bond is worth it for you.

But generally, junk bonds have been known to offer double-digit returns most of the time. For example, the returns were as high as 27.94% in 2003 and 54.22% in 2009, according to data from the Salomon Smith Barney High Yield Composite Index and the Credit Suisse High Yield Index (DHY). As with stocks, some years also made negative returns — for example, -26.17% in 2008 and -1.53% in 2002.

If you don’t want to risk it all in individual junk bonds, you can invest in junk bond ETFs to even out the risks while earning the accompanying huge returns.

Junk bonds rating

Junk bonds are usually rated Ba1/BB+ and lower by popular rating agencies such as Moody’s, Standard & Poor’s, and Fitch. By researching the bond issuer’s financial health, these agencies assign ratings to the bonds offered.

Those agencies have a similar hierarchy to help investors assess that bond’s credit quality compared to other bonds. Standard & Poor’s and Fitch rate junk bonds BB+ or lower, while Moody’s rate them Ba1 and lower. See the table below for the ratings that fit into the junk bond status.

Source: Fidelity

Junk bonds and interest rates

Generally, interest rate changes tend to affect bond prices and yield — as interest rates go up, bond prices will go down. Junk bonds may be less sensitive to short-term rates, but they closely follow long-term interest rates. But most times, it may take a recession for junk bonds to significantly underperform.

Given the Fed’s 0.25 basis point increase in interest rates in March 2022, many experts still think that US junk corporate bonds are only likely to face only a modest downside from prospective impacts of shortages on credit fundamentals, but some advantages can be gained from careful industry weighting and credit selection.

Junk bonds advantages and disadvantages

As with any other investment vehicle, investing in junk bonds comes with some pros and cons. The advantages include the following:

  • Higher yields: Junk bonds generally offer higher yields than investment-grade counterparts. But in actual practice, the gain over investment-grade bonds may not be that much because there will be more defaults.
  • Higher expected returns: There is a potential for significant price increases should the company’s financial situation improve.
  • A signal for market risk: To some investors, an increase in buying interest of junk bonds serves as a market-risk indicator. If investors are buying junk bonds, it means that market participants are willing to take on more risk due to a perceived improving economy. On the other hand, if junk bonds are selling off with prices falling, it means that investors are more risk averse and are opting for more secure and stable investments.

There are also many disadvantages to investing in high-yield bonds. The disadvantages of high-yield bonds are as follows:

  • High default risk: Junk bonds have a high risk of default. The possibility of default makes individual bonds too risky in the high-yield bond market. You may want to avoid buying individual junk bonds directly due to the high default risk. It is better to go for junk bond ETFs and mutual funds if you want exposure in the junk bonds category.
  • Higher volatility: Junk bond prices tend to be much more volatile than their investment-grade counterparts, and their volatility tends to follow the stock market more closely than the investment-grade bond market.
  • Higher interest rate risk: Another disadvantage of investing in junk bonds is that yields get eroded when there is a weak economy and rising interest rates. As interest rates go up, bond prices will go down. Although junk bonds are less sensitive to short-term rates, they closely follow long-term interest rates.

How to buy junk bonds

If you are looking for how to make money with junk bonds, you may first have to make your junk bond list. Buying junk bonds is like buying stocks: you choose the ones you want to buy and place your order via your broker if it’s a full-service brokerage. Many full-serve brokers participate in a secondary bond market to buy or sell bonds on behalf of their clients and to also access new bond issuances.

Note that a bond listing in the secondary bond market might look like this: Tesla Bond 8.625% 2/15/2028. As you can see, the first thing is the name of the organization that issued the debt, followed by the coupon rate (which shows a percentage of the face value of the bond at maturity). The last item is the maturity date, which shows when the investors will be repaid their capital.

If you consider buying individual junk bonds very risky, you may consider buying junk bond ETFs and mutual funds. They are usually considered better choices for retail investors interested in the high yields that such bonds offer. Junk bond mutual funds and exchange-traded funds (ETFs) allow you to benefit from the higher yields without the undue risk of investing in one junk bond that defaults. An example is the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).


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