Junk bonds are an interesting investment vehicle that are better suited to more seasoned investors comfortable with taking risk as opposed to beginners who are new to investing. The common question to ask at this point is obviously “what is a junk bond?”. A junk bond is a bond that has been rated below investment grade by a major credit rating agency; they are also referred to as high-yield bonds at times. For example, according to Standard and Poor’s methodology, a junk bond has a rating below BBB. Looking at bond ratings is an important step in their evaluation.
Sometimes, managed funds contain junk bonds within their portfolio. For instance, the Credit Suisse High Yield Bond Fund (DHY) is comprised entirely of junk bonds. Bonds like these are referred to as junk bonds because the risk of the bond defaulting is greater if they are rated below investment grade.
How are bonds rated?
Bond rating agencies such as Moody’s or Standard and Poor’s evaluate bonds based on a number of factors. Essentially, they are looking to determine how credit worthy the bond issuer is. This means a determination must be made as to whether there is a strong likelihood that the interest and principal on the bond will or will not be repaid by the borrower. Rating agencies typically review financial statements, financial forecasts and outlooks, the political and cultural environment within the region and the possibility for external threats or competition that could negatively impact a borrower’s ability to pay.
Why is it important?
Designating a bond as a junk bond is significant because many mutual funds and pension funds have restrictions about what assets they can invest in, and some are prohibited from trading junk bonds because of their perceived risk. As a result, if a bond is downgraded to junk status by a rating agency due to a reduction in credit worthiness, many funds will be forced to sell these bonds. Such selling action can drive the price of bonds and even funds that formerly owned them down; this in turn drains profits from investors.
In addition, if the borrower wishes to issue new debt, they will be forced to borrow at a much higher rate. This higher yield is to compensate investors for taking on the additional risk that junk bonds entail. Moreover, they must be compensated with a higher interest payment to balance out this heightened risk. The riskier a company is perceived to be, the higher an interest rate they will be required to pay on their debt issuances.
It is clear that junk bonds are an interesting asset class with a fair share of nuances and intricacies. Hopefully, this article has provided some insight about what junk bonds are and why they are relevant in today’s society. Being familiar with the risks and potential rewards of investing in junk bonds is a key part of investment planning success.