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What are Junk Bonds?

What are Junk Bonds?

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  • GS 3 || Economy || Banking & Financial Sector || Basics

What are junk bonds?

  • Junk bonds: Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments.
  • Bond: A bond is a debt or promises to pay investors interest payments and the return of invested principal in exchange for buying the bond.
    • Bonds are fixed-income debt instruments that corporations and governments issue to investors to raise capital.
      • When investors buy bonds, they’re effectively loaning money to the issuer who promises to repay the money on a specific date called the maturity date.
      • At maturity, the investor is repaid the principal amount invested.
      • Most bonds pay investors an annual interest rate during the life of the bond, called a coupon rate.
    • For example, a bond that has a 5% annual coupon rate means that an investor who purchases the bond earns 5% per year. So, a bond with a Rs. 1,000 face—or par—value will receive 5% x Rs. 1,000 which comes to Rs. 50 each year until the bond matures.
  • Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.

Higher Risk Equates to Higher Yield

  • A bond that has a high risk of the underlying company defaulting is called a junk bond. Companies that issue junk bonds are typically start-ups or companies that are struggling financially.
  • Junk bonds carry risk since investors are unsure whether they’ll be repaid their principal and earn regular interest payments.
  • As a result, junk bonds pay a higher yield than their safer counterparts to help compensate investors for the added level of risk.
  • Companies are willing to pay the high yield because they need to attract investors to fund their operations.
  • Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default.

Pros

  • Higher return: Junk bonds return higher yields than most other fixed-income debt securities.
  • Potential of price increases: Junk bonds have the potential of significant price increases should the company’s financial situation improve.
  • Risk indicator: Junk bonds serve as a risk indicator of when investors are willing to take on risk or avoid risk in the market.

Cons

  • High risk: Junk bonds have a higher risk of default than most bonds with better credit ratings.
  • Volatile: Junk bond prices can exhibit volatility due to uncertainty surrounding the issuer’s financial performance.
  • Market downturns: Active junk bond markets can indicate an overbought market meaning investors are too complacent with risk and may lead to market downturns.

Junk Bonds as a Market Indicator

  • Surge in junk bond investing usually translates to increased optimism: Some investors buy junk bonds to profit from potential price increases as the financial security of the underlying company improves, and not necessarily for the return of interest income.
  • As a result, increased buying interest of junk bonds serves as a market-risk indicator for some investors.
    • If investors are buying junk bonds, market participants are willing to take on more risk due to a perceived improving economy.
  • Conversely, if junk bonds are selling off with prices falling, it usually means that investors are more risk averse and are opting for more secure and stable investments.
  • It’s important to note that junk bonds have much larger price swings than bonds of higher quality.
  • Investors looking to purchase junk bonds can either buy the bonds individually through a broker or invest in a junk bond fund managed by a professional portfolio manager.

Improving Financials Affect Junk Bonds

  • If the underlying company performs well financially, its bonds will have improved credit ratings and usually attract buying interest from investors.
  • As a result, the bond’s price rises as investors flood in, willing to pay for the financially viable issuer. Conversely, companies that are performing poorly will likely have low or lowered credit ratings. These falling opinions might cause buyers to back off.
  • Companies with poor credit ratings typically offer high yields to attract investors and to compensate them for the added level of risk.
  • The result is bonds issued by companies with positive credit ratings usually pay lower interest rates on their debt instruments as compared to companies with poor credit ratings. Many bond investors monitor the credit ratings of bonds.

Mains question

  • What are Junk Bonds? What are the merits & demerits of Junk Bonds?