Junk Bonds and Why Investors Choose to Take on the Additional Risk

As a general rule in investing, opportunities that come with a lot of risk also have the promise of a high reward. This is the reason that investors will purchase securities like distressed debt or even junk bonds. The term junk likely reminds you of that box of stuff in the attic that needs to get thrown out and it gets applied to corporate bonds that are not considered to be investment grade. Because these bonds come with considerable risk, they have the potential for a much higher yield than investment grade corporate bonds. The decision to invest in junk bonds depends on your risk tolerance and the risk profile of the rest of your portfolio.

The Rating Structure for Corporate Bonds

When you begin to look at corporate bonds, you will notice that each has a credit rating from agencies like Standard & Poor’s (S&P), Fitch, and Moody’s. These ratings refer to the creditworthiness of the company issuing the bond. A junk bond has a credit rating of BB or below from S&P and Fitch or a rating of Ba or below from Moody’s. Notably, these scores change over time so it is important to look at the historic trends. Some companies may have a credit rating that is improving over time, which means that it could become investment grade at some point in the near future. Other companies may have credit scores trending the opposite direction, which indicates that they may be in some financial distress and carry greater risk. Companies with lower credit scores have to pay higher interest on bonds to attract investors.

The category of junk bonds includes a range of credit scores so it is important to recognize what the different categories mean. Companies that have a Ba or B from Moody’s or a BB or B from S&P mean that the bond is high risk. These ratings indicate that the company is currently capable of making the required payments but that it likely could not if business conditions worsen or the overall economy becomes more challenging. These companies tend to be vulnerable to adverse market conditions. If the company has a Caa, Ca, or C from Moody’s or a CCC, CC, or C from S&P, it is considered the highest risk. This means that business and economic conditions need to be favorable for the company not to default. Companies already in default have a C from Moody’s or a D from S&P.

The Attraction of Junk Bonds for Investors

Investors choose to purchase junk bonds because they can make more money than they would with bonds that have higher credit ratings. At the same time, these bonds still have the benefit of balancing out the volatility of stocks. Bonds provide fixed interest payments and junk bonds are still less risky than stocks in some ways. For example, if the company does go bankrupt, then bondholders tend to get paid before the stockholders. At the same time, junk bond investors need to pay close attention to the stock of the issuing company since the performance of junk bonds is often closely linked to the performance of stock. This makes sense since a company that is struggling will likely have stock that is losing value.

Investors often time their purchase of junk bonds to the business cycle. Junk bonds perform best during the expansion phase. Since the expansion phase indicates that things are going well for the company, default becomes much less likely. Investors also pay close attention to overall economic conditions and the performance of the business’ industry since these also play into the overall risk. However, the timing can get tricky. Most junk bonds are issued with a maturity of 10 years although they can mature in as little as four years. Also, junk bonds tend to be non-callable for a period of three to five years, which prevents the bond from being paid off early should conditions or credit rating improve, which protects the income of investors.

The Bottom Line for Investing in Junk Bonds

Overall, investing in junk bonds comes with a lot of benefits for people who can handle the higher risk. Investors receive a significantly higher interest rate than comes with investment-grade bonds while still carrying lower overall risk than with stocks, especially since bondholders get paid first in the event of bankruptcy. Most junk bonds provide ongoing coupon payments until maturity as with investment-grade corporate bonds and these recurring payments can significantly boost a portfolio. Furthermore, junk bonds provide a degree of diversity for a portfolio that can be protective for investors. Of course, investors also need to accept that companies could default or go bankrupt at any time, especially if the economy takes a downturn. Also, if the bond rating falls, the market price also drops since future investors will want a higher yield.

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