Junk bonds are high-yield corporate or government bonds with a high credit risk. The term is often used to describe bonds rated below investment grade. These bonds offer higher yields to compensate for the increased risk of default by the issuer. Because of this additional risk, they are also known as high-yield bonds.
Characteristics of junk bonds
Junk bonds have the following characteristics:
- High yields: Junk bonds offer higher interest rates than investment-grade bonds to attract investors. This is necessary to compensate for the higher risk that the issuer may not be able to meet interest payments or repay principal at maturity.
- Default risk: Junk bonds are issued by companies or entities with poor financial solvency or uncertain economic prospects. These bonds are considered riskier, as there is a higher probability that the issuer will default, i.e. be unable to repay the debt.
- Lower credit ratings: Junk bonds have credit ratings below BBB- from Standard & Poor’s and Fitch, or Baa3 from Moody’s. These ratings reflect the perceived credit risk of the issuers. The lower the rating, the higher the risk of default.
Why invest in junk bonds?
Despite the high risk, junk bonds attract some investors because of several potential advantages:
- Attractive yields: Investors can receive higher interest payments than those offered by higher-quality bonds. This can be particularly attractive in a low-interest-rate environment, where yields on investment-grade bonds are low.
- Diversification: For investors looking to diversify their bond portfolios, junk bonds can offer exposure to distressed or fast-growing companies, potentially from riskier but high-yielding sectors.
- Capital gains potential: If the issuer’s financial situation improves, its credit rating may be upgraded, which could increase the value of its bonds. This could enable an investor to resell the bonds at a higher price.
The risks of junk bonds
- High default risk: The main risk associated with junk bonds is the risk of default. The companies issuing these bonds are often facing financial difficulties or uncertain economic prospects. If the issuer defaults, investors may lose part or all of their investment.
- Increased volatility: Junk bonds are more volatile than investment-grade bonds, as they are more sensitive to changes in economic conditions, issuer prospects and financial market fluctuations.
- Limited liquidity: Due to the riskier nature of junk bonds, they may be less liquid, i.e. it may be more difficult to buy or sell them quickly without affecting the price. Junk bonds are generally traded on less active markets.
- Sensitivity to economic cycles: Junk bonds are often more vulnerable to economic downturns. In times of recession, companies issuing junk bonds may be more affected by lower revenues and higher financing costs, increasing the risk of default.
Credit rating of junk bonds
Credit rating agencies, such as Moody’s, Standard & Poor’s and Fitch, assess the creditworthiness of bond issuers and assign ratings based on their ability to repay their debts. Here is an overview of the ratings corresponding to junk bonds:
- Ba1 or less at Moody’s
- BB+ or lower at Standard & Poor’s and Fitch
These ratings indicate that the issuer has a higher probability of default than those with investment grade ratings, but may still be able to repay its debt under certain conditions.
Example of the use of junk bonds
Junk bonds are often issued by companies in financial difficulty, growing companies with limited credit histories, or companies engaged in leveraged buyouts (LBOs). For example, a company seeking to raise funds for rapid expansion or restructuring may issue junk bonds to attract investors, offering higher yields to compensate for the perceived risk.
