What Are Junk Bonds (Explained: All You Need To Know)

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What are Junk Bonds?

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What Is Junk Bonds

Junk bonds refer to high-risk bonds issued by corporations that are not doing well financially.

In other words, junk bonds are high-yield corporate bonds issued by companies that have a high risk of default due to their financial situation.

The reason why these types of bonds provide a higher yield than other bonds is that since the investor is exposed to a greater level of default risk, the expected return is therefore higher.

Companies issuing bonds are essentially borrowing money from investors and promising to pay back the principal along with interest in a specified timeframe.

When the borrower does not have a good credit rating or is struggling financially, investors will accept to lend money provided they are rewarded with higher interest.

Investors buying junk bonds are taking the bet that the company will be able to financially manage to pay the interest and principal.

However, if the company is unable to pay off its debt, the bondholders have the ability to push the company into bankruptcy, have the company liquidated, and have their bonds paid off.

Keep reading as I will further break down the meaning of junk bonds and tell you how they work.

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How Do Junk Bonds Work

Junk bonds are essentially corporate bonds or bonds issued by organizations having poor credit ratings.

They are called “junk” bonds as they are high-risk investment instruments.

Well-known fund managers and investment funds will not invest in junk bonds due to the issuer’s higher potential of default on its debt obligations.

However, fundamentally, a junk bond is a bond where an investor loans money to a company that promises to pay the money back along with interest.

Most bonds will pay investors an annual interest payment, called a coupon payment.

Then, at the maturity date of the bond, the principal is returned back to the investor.

For example, if a company issues a bond having a $1,000 face value and gives the investor 8% coupons over five years, the investor will get five coupon payments of $80 during the five years and at maturity, the company will pay back the face value.

When dealing with junk bonds, since the borrower has a poor credit rating, if it ends up having financial difficulties during the five years, it may default on the coupon payments or be unable to pay back the face value.

If that happens, company creditors will then bring the company into bankruptcy in an attempt to liquidate the business and get its money back.

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Why Junk Bonds Have Higher Yields

Junk bonds have higher yields as the issuer (or borrower) has a poor credit rating, may have financial difficulties, liquidity issues, and a higher risk of defaulting on its debt obligations.

Many investors will prefer to invest in safer bonds such as government bonds or those issued by blue chip organizations having solid credit ratings.

However, some investors are attracted by junk bonds particularly as the payoff can be much higher than low-risk bonds.

To compensate investors for taking more risk, junk bonds offer higher yields allowing investors to make more money for the extra risk they are taking.

Another key advantage of investing in junk bonds is that if the company’s credit rating improves or the financial situation gets better, the junk bond can generate additional returns for the investor.

Just like any investment offering high yields, investors should carefully assess their options and determine if the investment is right for them.

An investor that only looks at the bond yield and invests significant sums of money can potentially lose his or her investment if the company goes bankrupt.

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Why Invest In Junk Bonds

There are many reasons why some investors particularly enjoy investing in junk bonds.

The first reason an investor will choose junk bonds over other instruments is that he or she expects that the underlying company will not default on its debt obligation.

As a result, the investor takes the bet that the company will be able to financially maintain itself in good posture and honor the coupon payments and face value.

In this case, the investor makes money through higher yields.

Another reason why an investor may choose a specific junk bond is that the investor believes that the company’s financial situation will improve over time.

This can be the case for companies that are financially struggling due to an economic downturn but will do better as the economy improves.

Also, as the economy improves and the issuer’s credit rating improves, the investor stands to generate further gains through the gained market interest in this issuer’s bonds.

The more the company becomes financially stable, the more other investors will be attracted to buying its bonds leading to a rise in the bond prices.

A third important reason why an investor may invest in junk bonds is that he or she believes that even if the company defaults on its debt obligations, it has enough assets to be liquidated to pay off creditors.

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Junk Bond Credit Rating

There are different credit rating agencies that assess the creditworthiness of issuers guiding investors as to the potential risk they may be exposed to.

When a company has good credit ratings, it means that it is financially stable and can pay its financial obligations without exposing the investor to default risk.

On the other hand, a company with a poor credit rating is one that exposes the investor to higher levels of default risk and may have financial difficulties.

Companies like Standard & Poor’s have come up with a rating system where they assign different ratings to companies going from AAA (which is an excellent rating) to D (which means the company is in default).

Here is the credit rating scale used by Standard & Poor’s:

• AAA: excellent credit rating
• AA: very good credit rating
• A: good credit rating
• BBB: adequate credit rating
• CCC: vulnerable to nonpayment
• C: highly vulnerable to nonpayment
• D: in default

Bonds that are rated AAA, AA, A, and BBB are considered investment grade whereas bonds rated CCC, C, and D are “junk bonds”.

You have other rating agencies as well such as Moody’s Investor Service and Fitch Ratings.

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Takeaways 

So there you have it folks!

What does junk bond mean?

In a nutshell, junk bonds are corporate bonds issued by companies that do not have an investment-grade credit rating.

This means that junk bonds are riskier investments exposing investors to a greater risk of nonpayment by the issuer.

However, in exchange for the greater risk, investors are given higher yields.

There are institutional buyers such as pension funds, mutual funds, banks, and insurance companies that may purchase junk bonds as part of their investment strategy.

However, since junk bonds are not investment grade, there are many institutional investors that are prohibited to invest in junk bonds.

Just like any other investment, be sure to assess your options, study the issuer’s financial capacity, and consult an investment advisor before making important decisions.

Good luck!

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