There is a specific type of investment that is a fixed-income investment that gives periodical and fixed interest payments to investors. One of the well-known examples of this investment is the bond. Bonds have a credit rating included in the grading system and are conducted by credit rating agencies. They will tell us whether a bond is an investment grade or non-investment grade. Investment grades have credible issuers, and they only pose a low default risk. On the other hand, a bond can be classified as a non-investment grade if its issuers have low credit ratings and pose a higher default risk. The latter is also what we call the “junk bonds.”
What are junk bonds?
Unlike most bonds with corporations and governments as issuers, junk bonds have a high potential risk for default. Imagine this: a startup company needs more funds for more projects to continue to function. So, it will look for ways to generate capital, and this includes offering bonds to investors. This is a debt that a company issues with a promise to return the said principal money at maturity and additional interests. Usually, bonds pay an annual interest throughout the life of a bond that we call “coupon rate.”
In a typical setup, if a person is borrowing money for you, you would think twice. But what if the borrower offers to return the same amount at a specific time and pay you interests in the interim? Isn’t that a great deal? If that person is credible and you are not doubtful whether you’ll still get your money back, it sure is. This is the role of the credit-rating companies. They let investors know the worth of the bond and the credit rating of the issuer.
The price that junk bond issuers are willing to pay
Junk bonds are not very different from the typical corporate bonds if we compare them technically. The only fact that sets them apart is that junk bonds have a weaker credit rating. Junks bonds are usually from companies that are either struggling or just starting. Hence, these companies are willing to pay more to attract investors.
Let us assume that you are an investor and you are given two bond options: one bond is from a stable company that will surely pay you back with interests, and the other offers you the same, but there is a risk that they will not repay you. You do not even need to think about the answer, right? So, junk bonds need to step up their game and give the investors something to think about. Junk bond issuers are willing to give more; they have to. They at least have to pay the investors for the risk they are ready to make for this bond.
Is a junk bond worth it?
Let’s head on to the pros and cons of junk bonds. Let’s start with the benefits. Junk bonds have higher yields, and the price can increase more if the company’s finances improve. Also, if investors take this risk, it could serve as an indicator to another investor and develop more trading ideas.
However, junk bonds also have their share of downsides. They have more risks of defaults. They tend to be more volatile because of the issuer’s financial situation. Also, when a junk bond is active, it means that the market is in an overbought condition since investors became too comfortable with risks. This can also cause market downturns. Before engaging in this type of bond, you need to weigh these pros and cons well.