Many investors, especially new ones, think junk bonds are investment scams. While the term does seem a bit off, do not let it fool you. As worthless as this investment sounds, it most likely made its way in your portfolio, especially if you have a bond fund. Are you new to junk bonds and wondering whether they are beneficial for investors? Continue reading this article to learn the fundamentals and essentials of junk bond investing.
What are Junk Bonds?
You’d be surprised to learn that junk bonds offer high returns with drastically low credit ratings than municipal bonds, treasury bonds, and corporate bonds (investment grade.) In most cases, junk bonds have low ratings provided by financial service companies like Moody’s or Standard and Poors.
From a technical point of view, junk bonds share several similarities with regular bonds. It would be fair to say that junk bonds are like an IOU from organizations or corporations stating the principal amount they will return, its maturity date, and the coupon you will get for the borrowed money. However, junk bonds stand out because of the credit quality of their issuers.
For those who do not know, investors and financial organizations characterize bonds on their credit quality. So they fall into the following categories:
These bonds are excellent for bondholders looking for high yields, as borrowers don’t have other options. They have subpar credit ratings, which is why they have trouble acquiring capital at affordable costs. As discussed earlier, junk bonds are usually rated low (mostly BB) by well-reputed financial corporations like Moody’s or Standard and Poors.
Investment Grade Bonds
Medium to low-risk lenders mostly get investment-grade bonds. The rating on this bond type is mostly around AAA and BBB. While investment-grade bonds may not provide sizeable returns, the risk of interest payments default is remarkably smaller.
What are Bond Ratings?
Some of you reading this, especially aspiring investors, may be wondering what bond ratings are. Think of them as a report card containing the credit rating of a company. Blue-chip organizations that offer safer investments have higher ratings. On the other hand, you can expect low ratings provided by risky companies.
High Yields and High Risk
As mentioned earlier, the yields provided by junk bonds are significantly higher than traditional bond types, but the risk for defaults is also incredibly high. Historically, the average returns on junk bonds are mostly between four to six percent above other comparable bond types.
There are two junk bond categories:
Initially, fallen angels used to be an investment-grade bond, but it downgraded massively and found its way into the junk bond category. The subpar credit quality of this bond’s issuing company is a significant reason behind its poor status.
The rising star is vastly different from the fallen angel. Why? Because the credit quality of its issuing company has been on a steady incline and shows no signs of stopping. While the rising star is still a junk bond, its upward trajectory suggests that its investment quality will improve drastically.
Bond Defaults Explained
A bond becomes defaulted if it misses an interest and principal payment. The term “default” refers to the failure to pay back debts, including principal or interest on security or loans. As explained earlier, junk bonds have significantly high default risks due to their scarcity of adequate collateral and unpredictable revenue stream.
Furthermore, the bond default risk drastically increases when there are economic declines, adding an extra layer of risk to bottom level debts.
Who Should Buy Junk Bonds?
You must know some things before running out and asking your brokers to purchase every junk bond they can find. While there is nothing inherently wrong with this plan, there is a caveat – as discussed earlier, investing in junk bonds is risky. Some would even argue that it is the riskiest investment form.
There have been several cases where people never received their money back after investing in junk bonds. On the other hand, some investors struck gold and turned their lives around. Experienced investors with excellent analytical skills and knowledge regarding specialized credit are the best candidates to give junk bonds a go. You will notice a plethora of motivated and rich individuals investing in this bond type.
However, this does not mean that junk-bond investing is exclusive for wealthy individuals. In fact, utilizing bond funds with incredibly high yields makes sense for thousands of solo investors. These funds enable you to benefit from professionals with years of experience researching junk bonds. They also help diversify your investments in different assets to lower your risk.
It would be best to know the exact amount of time you can commit your money before buying a junk fund. Why? Because several junk bond funds don’t let investors cash out for before a year (usually year or two.)
Do the Rewards Justify the Potential Pitfalls?
Most junk bond investors go through a phase when the rewards do not justify the various risks linked with the investment. Every individual investor can find this out by taking a close look at the distinct yield spread between the United States Treasuries and junk bonds. As mentioned earlier, the return on junk is mostly around four to six percent above treasuries.
Steer clear from junk bonds if the yield spread shrinks lower than four percent. It would be best if you also looked for the junk bond’s default rate. Most investors check Moody’s site to get authentic rates.
Junk Bonds and Equities
Junk bonds and equities are not as different as you would think. The most notable similarity is that they conform to bust and boom cycles. Many bonds during the early 90s earned more than thirty percent annual returns. However, a massive influx of defaults produced a plethora of negative returns.
Despite their shady name, it would be fair to say that junk bonds are profitable investments for knowledgeable investors. However, their high return potential comes with incredibly high risk.