What Are Junk Bonds?

Have you ever wondered what “junk bonds” are and why an investor would be interested in them? Junk bonds offer high interest rates but also come with significant risks that make them inappropriate for many individual investors. However, by better understanding junk bonds, including their risks and potential rewards, you can determine if they have a place in your portfolio. 

Read on to learn the meaning of junk bond meaning, what makes a bond “junk”, which invests in these high-yield securities, and more.  

What defines a junk bond?

A junk bond, also referred to as a high-yield bond, is a type of loan that is given to a company that has a high chance of not being able to pay it back. This is because the company is considered to be risky and has a low credit rating. New companies, not doing well financially or in unpredictable industries, often issue what are called “junk bonds”.

Major credit rating agencies like S&P, Moody’s, and Fitch rate bonds based on the financial strength of issuers. Bonds with ratings below BBB- (S&P and Fitch) or Baa3 (Moody’s) are considered speculative grade securities, or “junk bonds” in common investor parlance. The lowest credit rating for bonds is D, indicating the issuer has already defaulted.

Why do companies issue junk bonds?

Companies that have a poor credit history may issue high-risk “junk bonds” as they can’t issue less risky “investment-grade” bonds. The reasons for this could be several:

• The company is yet to be profitable or has inconsistent earnings. This describes many startups and companies trying to grow quickly.
• The company operates in a cyclical industry like commodities, energy, or real estate. Its financial strength fluctuates significantly with economic cycles.
• The company has a heavy debt load or other financial problems and has been downgraded by rating agencies. In some cases, a formerly investment-grade firm may be demoted to a speculative-grade issuer if its finances decline.

What returns do junk bond investors expect? 

Given the substantial default risk assumed by junk bond investors, issuers must provide higher yields as an incentive. Historical data shows returns in the high single to low double-digit range for junk bond indexes and funds. 

For example, in 2021, the ICE BofA US High Yield index returned 5.35%. Meanwhile, the S&P 500 had a much stronger return exceeding 28% – but far less perceived risk. In weaker years like 2015 and 2018, that same high-yield index lost over 2% while still generally outperforming safer fixed income.

So, while returns aren’t spectacular in good times, junk bonds often hold up better than other bonds when markets decline. For investors, they provide increased diversification along with income.

What types of investors buy junk bonds?

Junk bonds appeal primarily to institutional investors like mutual funds, ETFs, pension funds, insurance firms, or speciality high-yield funds. They may dedicate a portion of their portfolios to higher-yielding junk bonds while balancing them with safer securities. Larger investors can also spread their risk over dozens or hundreds of bonds.

More risk-tolerant individual investors may also include junk bonds in their portfolios, using mutual funds or ETFs for easy diversification. However, financial advisors typically recommend limiting junk bond exposure to a small allocation in line with your risk tolerance. Those close to retirement or with low-risk tolerance may avoid junk bonds entirely.

Risks and downsides of junk bonds

While they offer temptingly high yields, junk bonds pose significant risks, including:

• Credit Risk: There is a high possibility that the payment of bond interest or the principal amount may be delayed or not paid at all. This risk increases significantly during economic downturns.
  
• Liquidity Risk: Junk bonds are not traded as actively as other bonds, so they are harder to sell at your desired price in the open market, especially during times of volatility. Investors may take a larger loss compared to the daily value of their junk bond fund.
  
• Interest Rate Risk: Like all bonds, prices fall when interest rates rise. Longer-duration junk bonds tend to suffer bigger declines. The low credit quality of junk bonds exacerbates the interest rate impact.

Junk bond yields and bond ratings

The lowest-rated junk debt pays the highest rates to attract capital but also has the most risk. CCC-rated bonds yield substantially more than higher BB and B issues that still count as “junk”.

Bond yields also depend heavily on the economic climate and investor sentiment. For example, at the depths of the COVID bear market in early 2020, junk bond yields shot up as high as 11% because so many companies struggled. In more normal times, yields range between 5-8% for most junk-rated issuers.

How to invest wisely in junk bonds

While no strategy can eliminate the intrinsic risks in junk bonds, following some prudence helps minimise surprises:

1. Limit overall allocation: Cap junk bond exposure to 5-10% of your overall portfolio

2. Build a diversified basket: Invest across 20-30 issuers across sectors to avoid concentration risk 

3. Avoid overextending on maturity: Stick to shorter 3-5-year maturities even if they offer lower yields; easier to ride out defaults

4. Monitor regularly: Follow rating actions closely to detect early signs of worsening financial health  

5. Hedge with safer bonds: Balance risky junk bonds with safer investment-grade corporate and government bonds

6. Use inverse junk bond ETFs: For seasoned investors, tools like inverse bond ETFs offer a way to profit from junk bond defaults  

Conclusion

When it comes to investing in bonds, there’s something called “junk bonds” that you may have heard of. Basically, these are bonds that are considered riskier than other types of bonds. So, whether or not you should invest in them depends on how comfortable you are with taking risks. If you’re someone who likes to play it safe, stick to government and corporate bonds that are considered very safe. But if you’re willing to take on a bit more risk in order to earn higher returns, you might consider investing in junk bonds. Just keep in mind that you want to invest only a little in these riskier bonds, especially as you get closer to retirement, because it may be harder to make up for any losses.

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