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What Is a Junk Bond?
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promise to pay investors interest payments along with the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.
Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default.
Deeper definition
A bond is a way of lending money to a company. The company accepts the money for the bond with the agreement that it repays the initial loan with interest when the bond matures. They usually have a credit rating from a financial services company like Standard & Poor’s that reflects the ability of the company to meet its payment obligations when the bond matures. A healthy rating means a bond is likely to generate a lot of revenue, which goes toward the bond issuer’s payments on its principal and interest. These bonds are called investment-grade.
Junk bonds have low credit ratings, meaning there’s a high risk of default or the potential for other adverse credit events. However, where long-term investors favor reliable, income-producing bonds, speculators may prefer to shoulder the risks of a high-yield, non-investment-grade bond.
Investors may expect the bond issuer’s revenue to pick up, if, for example, it’s in an industry undergoing a temporary slump. In that case, there’s potential for a significant windfall on a high-yield investment. But, absent any information about the company’s financial prospects, it’s just as likely that it’ll miss a payment and the purchaser could lose money.
Junk bonds also offer strong investment opportunities during periods when interest rates are low and more reliable investment options are offering poor returns. This is because the high yields and short maturities of junk bonds are less affected by interest rates, an increase in the issuing company’s revenue may improve the health of a junk bond even when interest rates stay low.
History of Junk Bonds
The United States government started using junk bonds in the 1780s as a way of financing an unproven government. At the time, the country’s risk of default was high. Therefore, not many international lenders were willing to lend unless the investment offered high returns.
Junk bonds returned in the early 1900s as a form of financing startups. Companies like General Motors and IBM were at their early stages at the time. Few banks were willing to extend credit to companies without a track record. In the 1970s and 1980s, the junk bond market experienced a boom due to fallen angel companies. Fallen angels are companies that had previously issued investment-grade bonds, but that experienced a drop in their credit rating.
Research published by Braddock Hickman, Thomas Atkinson, and Orina Burrell also contributed to the 1970s to 1980s boom. The study showed that junk bonds paid higher returns than was necessary to compensate for the extra risk involved. Drexel Burnham used this research to build a large junk bond market. Their investments in junk bonds grew from $10 billion to $189 billion between 1979 to 1989. The average returns stood at 14.5%, while the defaults were only 2.2%. Unfortunately, the market suffered a blow after Drexel was brought down by illegal trading activities. Drexel was eventually forced into bankruptcy.
Who Buys Junk Bonds?
The obvious caveat is that junk bonds are a high-risk investment. There’s a risk that the issuer will file for bankruptcy and you’ll never get your money back.
There is a market for junk bonds, but it is overwhelmingly dominated by institutional investors who can hire analysts with knowledge of specialized credit.
This does not mean that junk-bond investing is strictly for the wealthy.
Are junk bonds a good investment?
Although they pay higher yields, junk bonds also have unique risks that investors should be aware of before making any investment. Here are some the advantages and disadvantages of investing in junk bonds:
| Pros | Cons |
|---|---|
| Higher interest rates than for investment-grade bonds. | Comparatively high risk of the bond issuer missing an interest payment. |
| Lower risk of losing money as compared to stocks. | Greater fluctuations in trading prices relative to investment-grade bonds. |
| Junk bond prices are less volatile than stock prices during periods of economic uncertainty. | Subject to a partial or total loss of value if the issuing company declares bankruptcy. |
| Provide a steady stream of income at an attractive interest rate. | Not suitable as short-term investments since junk bond prices fluctuate in the years before maturity. |
Junk Bonds as a Market Indicator
Some investors buy junk bonds to profit from potential price increases as the financial security of the underlying company improves, and not necessarily for the return of interest income. Also, investors that predict bond prices to rise are betting there will be increased buying interest for high-yield bonds—even these lower rated ones—due to a change in market risk sentiment. For example, if investors believe economic conditions are improving in the U.S. or abroad, they might purchase junk bonds of companies that will show improvement along with the economy.
As a result, increased buying interest of junk bonds serves as a market-risk indicator for some investors. If investors are buying junk bonds, market participants are willing to take on more risk due to a perceived improving economy. Conversely, if junk bonds are selling off with prices falling, it usually means that investors are more risk averse and are opting for more secure and stable investments.
Although a surge in junk bond investing usually translates to increased optimism in the market, it could also point to too much optimism in the market.
It’s important to note that junk bonds have much larger price swings than bonds of higher quality. Investors looking to purchase junk bonds can either buy the bonds individually through a broker or invest in a junk bond fund managed by a professional portfolio manager.
Credit Ratings and Junk Bonds
Although junk bonds are considered risky investments, investors can monitor a bond’s level of risk by reviewing the bond’s credit rating. A credit rating is an assessment of the creditworthiness of an issuer and its outstanding debt in the form of bonds. The company’s credit rating, and ultimately the bond’s credit rating, impact the market price of a bond and its offering interest rate.
Credit-rating agencies measure the creditworthiness of all corporate and government bonds, giving investors insight into the risks involved in the debt securities. Credit rating agencies assign letter grades for their view of the issue.
For example, Standard & Poor’s has a credit rating scale ranging from AAA—excellent—to lower ratings of C and D. Any bond that carries a rating lower than BB is said to be of speculative-grade or a junk bond. This should be a red flag to risk-averse investors. The various letter grades from credit agencies represent the financial viability of the company and the likelihood that the contract terms of the bond terms will be honored.
Investment Grade
Bonds with a rating of investment-grade come from corporations that have a high probability of paying the regular coupons and returning the principal to investors. For example, Standard & Poor’s ratings include:
- AAA—excellent
- AA—very good
- A—good
- BBB—adequate
“Junk” (Speculative)
As mentioned earlier, once a bond’s rating drops into the double-B category, it falls into the junk bond territory. This area can be a scary place for investors who would be harmed by a total loss of their investment dollars in the case of a default.
Some speculative ratings include:
- CCC—currently vulnerable to nonpayment
- C—highly vulnerable to nonpayment
- D—in default
Companies having bonds with these low credit ratings might have difficulty raising the capital needed to fund ongoing business operations. However, if a company manages to improve its financial performance and it’s bond’s credit rating is upgraded, a substantial appreciation in the bond’s price could happen. Conversely, if a company’s financial situation deteriorates, the credit rating of the company and its bonds might be downgraded by credit rating agencies. It is crucial for investors in junk debt to fully investigate the underlying business and all financial documents available before buying
Real World Example of a Junk Bond
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 October 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.
Also, the current price of the Tesla offering is $577 as of Oct. 2020, much higher than its 2014 $100 face value, which represents the extra yield that investors are getting above the coupon payment. In other words, despite the BB- rating, the bond is trading at very large premium to its face value. This is because the bonds are convertible to equity. Thus, with shares of Tesla soaring 600% over the last twelve months ending Oct. 26, 2020, the bonds are proving to be valuable surrogates for the equity.
Examples of junk bond companies
Quite a few well-known companies have below-investment-grade credit ratings. Notable businesses with credit ratings that give them “junk” status include:
- Ford (NYSE:F): Ford has been rated as investment-grade in the past, but the company lost its investment-grade ratings in 2020 due to the coronavirus pandemic and global economic collapse. Its junk bonds still trade at a premium, reflecting the company’s legacy status.
- Tesla (NASDAQ:TSLA): Tesla is a younger, newer company, and its junk-rated debt is a product of its financial track record. Its focus on growth has caused Tesla to only very recently start generating positive free cash flow, although the company is making progress toward becoming investment-grade.
- Netflix (NASDAQ:NFLX): Netflix also falls into this category of growth-oriented companies. The company generated negative free cash flow for years to pay for new content creation for its streaming service, issuing junk bonds as part of its strategy to fund in-house production of movies and TV shows. Netflix’s bonds, which also trade at a premium, have gained slightly more value as the company has gotten closer to producing positive free cash flow. The company’s improving credit rating makes it likely that Netflix will eventually achieve investment-grade status.
Junk bonds are a significant part of the bond market, but that doesn’t mean they should be a big part of your portfolio. For many individual investors, it’s OK to skip junk bonds completely. For others, this type of holding should represent a relatively small portion of your portfolio and is best purchased through diverse ETFs.
Unlike that pile in your basement, you may find junk desirable for your investment portfolio. Just invest carefully and make sure you understand the risks before hitting the buy button.
