What Are Junk Bonds?

People invest in two of the most widely invested asset classes: Equities and Debt. While they may start their investment journey with equities, they tend to diversify into debt to earn regular income in the form of interest. The motive behind such investments is to offset the losses made in the equity market if it goes through a bear cycle. In the debt asset class, investors choose bonds as a viable investment. Although bonds come with lower risk, they include a category known as junk bonds that may force the investors to incur hefty losses. Hence, it is vital to understand the junk bond definition.

What are Bonds, and how do they work?

Bonds are certificates/letters given in exchange for simple/complex loans. They are financial instruments that large corporations or the government issue to raise money from the public. People invest in the bonds of various companies or the government to realise regular payments of interest, and the issuer uses the money to fund its business operations. Bonds come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.

Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market. The bondholders receive regular interest based on the interest rate (coupon rate) at regular intervals until maturity or until the bondholder holds the bond. At the end of the maturity, the issuer repays the principal amount to the bondholder.

However, not all bonds have the ability to provide regular interest and repay the principal amount at the time of maturity.

What are Junk Bonds?

Junk bonds are a type of bond that carries a higher risk of default. The issuer of such bonds may not have the adequate cash flow to pay regular interest or repay the principal amount to the bondholders at the time of maturity. The bonds issued by financially struggling companies are termed junk bonds and generally have higher yields as it is only through a high yield that junk bonds can offset any risk of default.

Junk bonds definition has allowed credit rating agencies to give a lower credit rating to junk bonds as the risk is higher for the bondholders who invest in such bonds. However, companies that issue junk bonds make them attractive to investors by accompanying them with higher coupon rates, called junk bond rates.

Understanding Junk Bonds

Typically, bonds are issued by two entities: the government and private companies. The bonds issued by governments are known as government securities, while the bonds issued by private companies are called corporate bonds. Government securities are considered the safest option as it is highly unlikely for a government to have inadequate cash to pay interest or repay the principal amount. However, corporate bonds carry higher risk as private companies may become financially weak at any time and be left with inadequate cash for payments.

Junk bonds are part of corporate bonds but differ as they are issued by companies that are not financially strong. The issuer carries a poor credit rating which is visible to every investor before investing. Although these companies promise to pay the interest at regular intervals and repay the principal amount at the time of maturity, the promise is limited to the time the company has a positive cash flow. To compensate for the high risk of default, the issuer attaches a high junk bond rate to the bond to allow investors with a high-risk appetite to invest in the company’s junk bonds.

Generally, startups or companies that have a bad financial reputation issue junk bonds and let investors know that there is a high possibility that the company may fail to fulfil the payment promise. In such a case where the company fails to pay interest or repay the principal amount, investors incur huge losses by losing their invested capital.

Junk Bonds and Investment Grade Bonds

Right from the day junk bonds are issued by companies, they carry a high risk of default. However, investors can monitor a junk bond’s level of risk by constantly monitoring its credit rating. A regular bond with a good credit rating may be termed a junk bond because of the company making huge losses in its operations. The same may be the case for a junk bond, which may get a better credit rating if the company makes good profits and increases its cash flow. Ultimately, the credit rating of the company and subsequently of the issued bonds is what makes a bond termed a junk bond.

On the other hand, bonds of companies that are financially strong and have adequate cash to pay interest and repay the principal amount are rated with an investment-grade credit rating. The bonds that have an investment-grade credit rating come with negligible risk of default and a high possibility of timely payment and repayment. Junk Bonds are generally rated as below the BB rating, which can go down to C or D. Investment grade bonds are rated AAA, AA, A or BBB representing their risk profile and the presence of positive cash flow.

Who Buys Junk Bonds?

Junk bonds are a highly risky investment but come with a high coupon rate. Investors who have a high-risk appetite analyse companies issuing junk bonds to understand if the company will default on payments or repayments. If they think there is a slight chance that the company may fulfil the promise, they invest in junk bonds. However, it is highly advised to do thorough research before investing in junk bonds as you may lose the invested capital in bonds that come with lower than BB credit rating. Hence, investors who have a high-risk appetite and are comfortable in incurring losses amounting to the invested capital invest in junk bonds.

Conclusion

Although junk bonds have a lower credit rating and come with high risk, investors may fall for the high junk bond rates. It may allow you to earn better interest than other bonds but the period of regular interest payments is unknown. As investment-grade bonds are available, it is wise to invest in such bonds and keep away from junk bonds to ensure you do not lose your invested amount and realise a regular source of income.