Junk Bond

Junk bonds are fixed-income debt instruments offering higher yields than conventional corporate bonds with a higher risk of default and volatility. These bonds are attractive to investors as they guarantee significant returns on investment with increased interest payments. Companies and governments issue these bonds with a high debt ratio and a low investment-grade credit rating.

These bonds, also known by names of high-yield, speculative-grade, or non-investment-grade bonds, could see huge price gains if the issuer’s financial status improves. Also, these act as economic indicators, with rising prices indicating better economic conditions and falling prices indicating poor economic health.

• Junk bond definition depicts it as high-yielding financial securities with a higher risk of default and volatility than traditional corporate bonds.
• Companies and governments with a high debt ratio and a low investment-grade credit rating issue these bonds with a 4-10 year maturity period.
• Speculative-grade bonds have a credit rating of BBB or lower from S&P or Fitch, or a credit rating of Baa or lower from Moody's.
• High-yield bonds serve as economic indicators, with higher prices suggesting a better economic situation and lower prices indicating a worsening financial condition. Also, these show whether investors can take on risk (by purchasing it) or avoid risk (by selling it).

Junk bonds are below-investment-grade bonds and have a low credit rating from a rating agency. Like regular corporate bonds, these bonds promise investors to receive the principal amount, along with fixed interests at maturity. These bonds allow investors to earn higher returns than conventional investment vehicles due to the higher risk involved.

Corporations that are new to the market, have recently experienced financial difficulties, or have a poor credit rating issue high-yield bonds. Hence, it is highly likely that they will default on principal and interest payments. Bonds with an S&P or Fitch credit rating of BBB or lower, or a Moody's credit rating of Baa or lower, are classified as speculative-grade bonds.

The bond is referred to be a "Rising Star" if its credit rating is improving and it is on its way to becoming an investment-grade bond. If, on the other hand, the credit rating falls, it is classified as a "Fallen Angel," and it is on its way to becoming a speculative-grade bond.

As stated, companies that struggle to retain their market share generally issue high-yield bonds. These bonds often offer higher yields, which increase further when the issuer's financial condition improves. These typically have a 4-10 year maturity term and substantially bigger price volatility. Investors invest in high-yield assets to benefit from future value appreciation rather than earning interest. Furthermore, bondholders are the first to get returns if the company goes bankrupt or liquidates.

The high-yield junk bond market is dominated by institutional investors with specialist credit-related knowledge, although not limited to them. The bond indicates whether investors can take the risk (by buying it) or avoid risk (by selling it). The decision to purchase speculative-grade bonds depends on the investment period, expected returns, and level of risk that investors can take.

1. Buying high-yield bonds is straightforward and similar to purchasing other securities.
2. When listed on the secondary bond market, it reflects the issuer's name, coupon (interest) rate, and maturity date.
3. The bond can be purchased individually or through a broker or by investing in a mutual fund or electronically traded fund.

Let us take into consideration the following junk bond examples to understand how it works:

#1 - Ford

Ford (NYSE:F) began as an investment-grade bond provider, but amid the COVID-19 pandemic in 2020 and a global economic collapse, it lost its ‘Rising Star’ status and moved to a junk bond rating. As a result, it began issuing high-yield bonds, which continue to trade at a premium due to the brand's strong market reputation.

#2 - Netflix

As a growth-oriented corporation, Netflix (NASDAQ:NFLX) provided its streaming services to customers for free for an extended period, which resulted in a negative cash flow. Therefore, it issued high-yield bonds as part of its attempt to compensate for its financial difficulties.

The value of Netflix bonds has increased significantly. It put them in the ‘Rising Star’ category, improving its junk bond rating and enabling it to achieve the investment-grade bond status in the future.

#3 - Coinbase

Coinbase is a cryptocurrency exchange that has grown in popularity due to increasing investments in Bitcoin, Dogecoin, etc. As a result, the exchange witnessed a spike in demand for high-yield bonds in September 2020. It, thus, issued $1.5 billion in seven- and 10-year bonds at first. However, the exchange was later forced to sell $2 billion in bonds because of overwhelming demand.

Junk bond yields are higher due to increased risk and interest payments. As previously indicated, these bonds are issued by corporations on the verge of going bankrupt. They issue bonds to get themselves out of the difficulty and fund their operations. They do this to entice investors by promising them the principal amount plus interest at maturity, more than conventional bonds. The issuer, thus, rewards investors for taking on additional risks. However, if the company could not maintain its position, it might default and not repay investors the promised profits.

On the other hand, higher yields encourage more investors to participate in sinking firms' high-yield bonds. It allows them to perform well and float in the market again, improving their credit ratings and increasing bond prices.

This has been a guide to junk bond and its definition. Here we explain how junk bonds work, their ratings, examples, features, and riskiness. You may also learn more about financing from the following articles -

• Yankee Bonds
• Bond ETF
• Bond Rating