Junk Bond

Article bySusmita Pathak
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Junk Bond?

Junk bonds are fixed-income debt instruments offering higher yields than conventional corporate bonds with a higher risk of default and volatility. These bonds are attractive to investors as they guarantee significant returns on investment with increased interest payments. Companies and governments issue these bonds with a high debt ratio and a low investment-grade credit rating.

What Is A Junk Bond

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These bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, also known by names of high-yield, speculative-grade, or non-investment-grade bondsInvestment-grade BondsInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more, could see huge price gains if the issuer’s financial status improves. Also, these act as economic indicatorsEconomic IndicatorsSome economic indicators are GDP, Exchange Rate Stability, Risk Premiums, Crude Oil Prices etc. read more, with rising prices indicating better economic conditions and falling prices indicating poor economic health.

Key Takeaways

  • Junk bond definition depicts it as high-yielding financial securities with a higher risk of default and volatility than traditional corporate bonds.
  • Companies and governments with a high debt ratio and a low investment-grade credit rating issue these bonds with a 4-10 year maturity period.
  • Speculative-grade bonds have a credit rating of BBB or lower from S&P or Fitch, or a credit rating of Baa or lower from Moody’s.
  • High-yield bonds serve as economic indicators, with higher prices suggesting a better economic situation and lower prices indicating a worsening financial condition. Also, these show whether investors can take on risk (by purchasing it) or avoid risk (by selling it).
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Understanding Junk Bond

Junk bonds are below-investment-grade bonds and have a low credit ratingCredit RatingCredit rating process is the process in which a credit rating agency (preferably third party) analyzes a security and rates it accordingly so that the stakeholders can make their investing decisions.read more from a rating agency. Like regular corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more, these bonds promise investors to receive the principal amount, along with fixed interests at maturity. These bonds allow investors to earn higher returns than conventional investment vehicles due to the higher risk involved.

Corporations that are new to the market, have recently experienced financial difficulties, or have a poor credit rating issue high-yield bondsHigh-yield BondsHigh yield bonds are bonds that pay higher interest than others but are assigned lower credit ratings by popular credit rating agencies. Ratings below “BBB” from Standard & Poor and below “Baa” from Moody’s are due to additional credit risks involved in interest and principal repayment.read more. Hence, it is highly likely that they will default on principal and interest payments. Bonds with an S&P or Fitch credit rating of BBB or lower, or a Moody’s credit rating of Baa or lower, are classified as speculative-grade bonds.

The bond is referred to be a “Rising Star” if its credit rating is improving and it is on its way to becoming an investment-grade bond. If, on the other hand, the credit rating falls, it is classified as a “Fallen AngelFallen AngelFallen angel bonds used to be high-rated bonds, but they've been labeled as junk bonds now. They're highly volatile and are very sensitive to the ever-changing economy.read more,” and it is on its way to becoming a speculative-grade bond.

As stated, companies that struggle to retain their market shareMarket ShareMarket share determines the company's contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company's market position when compared to that of its competitors.read more generally issue high-yield bonds. These bonds often offer higher yields, which increase further when the issuer’s financial condition improves. These typically have a 4-10 year maturity term and substantially bigger price volatility. Investors invest in high-yield assets to benefit from future value appreciation rather than earning interest. Furthermore, bondholders are the first to get returns if the company goes bankrupt or liquidates.

The high-yield junk bond market is dominated by institutional investors with specialist credit-related knowledge, although not limited to them. The bond indicates whether investors can take the risk (by buying it) or avoid risk (by selling it). The decision to purchase speculative-grade bonds depends on the investment period, expected returnsExpected ReturnsThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more, and level of risk that investors can take.

Junk Bond Features

  1. Buying high-yield bonds is straightforward and similar to purchasing other securities.
  2. When listed on the secondary bond market, it reflects the issuer’s name, coupon (interest) rate, and maturity date.
  3. The bond can be purchased individually or through a broker or by investing in a mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more or electronically traded fund.

Real World Examples

Let us take into consideration the following junk bond examples to understand how it works:

#1 – Ford

Ford (NYSE:F) began as an investment-grade bond provider, but amid the COVID-19 pandemic in 2020 and a global economic collapseEconomic CollapseAn economic collapse refers to a severe contraction in the economy led by an extraordinary event (financial or structural) which is not a part of the normal economic cycle. It may lead to a decline in national growth, a rise in unemployment, and sometimes social unrest; therefore, it requires government or monetary authorities intervention.read more, it lost its ‘Rising Star’ status and moved to a junk bond rating. As a result, it began issuing high-yield bonds, which continue to trade at a premium due to the brand’s strong market reputation.

#2 – Netflix

As a growth-oriented corporation, Netflix (NASDAQ:NFLX) provided its streaming services to customers for free for an extended period, which resulted in a negative cash flowNegative Cash FlowNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period.read more. Therefore, it issued high-yield bonds as part of its attempt to compensate for its financial difficulties.

The value of Netflix bonds has increased significantly. It put them in the ‘Rising Star’ category, improving its junk bond rating and enabling it to achieve the investment-grade bond status in the future.

#3 – Coinbase

Coinbase is a cryptocurrencyCryptocurrencyCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service.read more exchange that has grown in popularity due to increasing investments in BitcoinBitcoinBitcoin is a digital currency that came into existence in January 2009, speculated to be created by Satoshi Nakamato, whose true identity is yet to be authenticated. It provides lower transaction fees than the traditional online payment systems, is controlled by the decentralized authority, and is not like government-issued currencies.read more, Dogecoin, etc. As a result, the exchange witnessed a spike in demand for high-yield bonds in September 2020. It, thus, issued $1.5 billion in seven- and 10-year bonds at first. However, the exchange was later forced to sell $2 billion in bonds because of overwhelming demand.

Why Are Junk Bonds Risky?

Junk bond yields are higher due to increased risk and interest payments. As previously indicated, these bonds are issued by corporations on the verge of going bankrupt. They issue bonds to get themselves out of the difficulty and fund their operations. They do this to entice investors by promising them the principal amount plus interest at maturity, more than conventional bonds. The issuer, thus, rewards investors for taking on additional risks. However, if the company could not maintain its position, it might default and not repay investors the promised profits.

On the other hand, higher yields encourage more investors to participate in sinking firms’ high-yield bonds. It allows them to perform well and float in the market again, improving their credit ratings and increasing bond prices.

Frequently Asked Questions (FAQs)

What is a junk bond?

Junk bonds are non-investment-grade bonds and have a poor credit rating. Like regular corporate bonds, these bonds guarantee investors the principal amount, higher returns, and interest at maturity. Companies new to the market have recently had financial troubles, or have a bad credit rating, issue these bonds. As a result, they are likely to miss their principal and interest payments.

How are bonds classified as junk bonds?

A bond is referred to be a “Rising Star” if its credit rating is improving and it is on its way to becoming an investment-grade bond. Conversely, if the credit rating falls, it is classified as a “Fallen Angel,” thus becoming a junk bond. Speculative-grade bonds have an S&P or Fitch credit rating of BBB or lower or a Moody’s credit rating of Baa or lower.

What are the pros and cons of a junk bond?

pros and cons of a junk bond

This has been a guide to junk bond and its definition. Here we explain how junk bonds work, their ratings, examples, features, and riskiness. You may also learn more about financing from the following articles –

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