What is a junk bond? As the old saying goes, one person’s trash is another person’s treasure. And this couldn’t be more true than in the world of junk bonds. But before we get started, let’s have a quick recap on what exactly bonds are.
Table of Contents
- Five Second Takeaway: Junk Bonds
- An Example of Bonds At Work
Five Second Takeaway: Junk Bonds
- All types of bonds offer interest payments when they borrow money to attract investors.
- Junk bonds are a kind of bond or debt investment that is rated below investment grade.
- When a bond has a junk rating, the default risk is higher than investment-grade bonds.
- have higher default rates than investment-grade bonds
- They have increased risk but offer a higher interest rate than investment-grade bonds
What Is A Bond?
A bond is just a loan from an investor to a company or government. By issuing a bond, a company or government borrows money from investors, who, in return, are paid interest on the money they loan.
How do coupon rates fit into junk bonds, and what are they? The coupon rate is the fixed annual rate at which a guaranteed-income security, typically a bond, pays its holder or owner.
Why Do Companies And Governments Issue Bonds?
The short answer: is to fund new projects or ongoing expenses. Alternatively, some investors use bonds as a way to preserve their wealth while also generating additional income.
Bonds are often viewed as a less risky alternative to stocks and are sometimes used to diversify portfolios.
An Example of Bonds At Work
Consider this example. The City of Memphis wants to build a small skatepark but doesn’t have the $250,000 or so dollars it will take to finish it. So, they decide to issue bonds to raise money. Each bond costs $1000, which Fairview promises to pay back in 10 years.
To make this no more tractive to investors, the City agrees to pay an annual interest rate, a.k.a coupon rate of 5%. So now things look attractive to investors, and they buy bonds at face value of $4000.
Now, let’s fast forward. Each year the City of Memphis pays the investor $50. And for ten years, these fixed, regular interest rate payments continue. Once the bond reaches maturity, the investor redeems his bond, and the City of Memphis returns the initial thousand dollars principal investment.
Overall, this bond was a good idea for the City and the investor. The City got the money needed to build the skate park. And the investor got his regular interest payments and the return on their original investment.
Why are bonds viewed as a predictable and stable form of investing? Because a bond offers the investor regularly scheduled payments and the return of principal, they’re seen as a more predictable and stable form of investing.
How To Use Bonds As Part Of A Diversified Portfolio
Capital preservation income generation is just two ways bonds can be used to diversify a portfolio. Many investors use a mixture of stocks and bonds to pursue their investment goals. And because many bonds move differently from stocks, they can help increase or protect portfolio returns.
As you know, when you buy a bond, you’re lending money to the bond issuer. Once the bond matures, the issuer promises to repay you with interest. The thing is. However, not all companies can deliver on that promise.
Of course, like any investment, bonds carry risk.
The Risk Of Bonds
Issuer Default: One risk investors face is the possibility that the issuer defaults on paying back the principal. This is what is known as default risk.
Typically, bonds with a high default risk come with higher than normal coupon rates. Therefore, it should be no surprise that risk depends on the issuer’s stability.
Interest Rate Risk: Another thing one must consider when playing with junk bonds is interest rate risk. Or the risk that interest rates will go up. I this happens, you can expect its price in the bond market to decrease.
After all, when interest rates rise, more investors put their money into higher interest-rate bonds. So if you want to unload a low-interest-rate bond to take advantage of these new rates, you need to sell it at a discount to make it worthwhile for another investor to buy it.
Bonds that take longer to mature present the greatest risks in this respect.
Government Vs. Corporate Bonds
We can place bonds into one of two categories: government and corporate. Governments are typically considered stable entities. Hence, when they issue a bond, it has a relatively low coupon rate.
However, on the flip side, we place corporate bonds in the riskier category. This is because companies can and do go bankrupt. Hence, we see corporate bonds often associated with higher coupon rates.
What is a junk bond? A junk or speculative-grade bond is a high-yielding fixed-income security with a high risk of default on payment.
So how does one protect themselves? That’s where bond ratings come in. What are they? Several credit rating agencies assign letter grade rankings to different bonds. This can help investors to gauge the financial strength of the bond issuer.
Bond Rating Agencies
Like in school, bond ratings are letter grades issued by independent bond rating agencies. A’s and B’s are generally better and mean a high chance of repayment when the term ends. Conversely, lower letter grades signal the company’s bonds could be risky.
Standard & Poor, Moody’s, and Fitch are some household names for rating agencies. However, they often use different criteria for measuring risk. For these reasons, comparing ratings is important when buying a particular bond. And keep in mind reading agencies aren’t always accurate. So be sure to research a bond and its risks before investing thoroughly.
BBB Rated Bonds: Investment Grade Bonds: We consider bonds with a BBB (or Baa on Moody’s scale) rating or higher, “investment-grade” bonds. This means that the bond rating agency feels you’d likely get your money back.
Bonds Rated Below BBB/Baa: Junk Bonds: On the flip side, bonds rated below BBB have a high likelihood of failure regarding their ability to repay their debts. That is why we call them speculative-grade or non-investment-grade bonds—a.k.a. junk bonds.
So who issues junk bonds? Typically companies that are somewhat new or have had recent financial problems will turn to junk bonds to raise money.
The Appeal Of Junk Bonds
So why would one want to invest their money in something likely to leave you high and dry? As the old saying goes, the higher the risk, the higher the reward. And herein lies your answer. Some investors love junk bonds because of their potential for high returns.
To sweeten the pot, companies need to offer a high rate of return to convince investors to cough up their money. And over time, the payoff can be quite lucrative for investors.
Junk Bonds Outperforming Treasury Bonds
Yes, you read that right. Did you know that from 1983 through 2020, a diversified portfolio of junk bonds returned 8.8% compounded annually.? Contrastingly, a diversified portfolio of Treasury bonds returned 6.2% compounded annually.
Like any bond, a junk bond is an investment in debt. Like all investments, bonds are complex and have a variety of uses and risks. Therefore, before investing in bonds, you must do your homework to make the best investment decision for your financial goals.