What are junk bonds?
Junk bonds, or high-yield bonds, are risky investments that have higher rates of default but offer significantly higher returns. Unlike lower-risk, investment-grade bonds, junk bonds are not usually ideal for long-term investments, and can easily cause the investor to lose money if she’s not careful.
A bond is a way of lending money to a company. The company accepts the money for the bond with the agreement that it repays the initial loan with interest when the bond matures. They usually have a credit rating from a financial services company like Standard & Poor’s that reflects the ability of the company to meet its payment obligations when the bond matures. A healthy rating means a bond is likely to generate a lot of revenue, which goes toward the bond issuer’s payments on its principal and interest. These bonds are called investment-grade.
Junk bonds have low credit ratings, meaning there’s a high risk of default or the potential for other adverse credit events. However, where long-term investors favor reliable, income-producing bonds, speculators may prefer to shoulder the risks of a high-yield, non-investment-grade bond.
Investors may expect the bond issuer’s revenue to pick up, if, for example, it’s in an industry undergoing a temporary slump. In that case, there’s potential for a significant windfall on a high-yield investment. But, absent any information about the company’s financial prospects, it’s just as likely that it’ll miss a payment and the purchaser could lose money.
Junk bonds also offer strong investment opportunities during periods when interest rates are low and more reliable investment options are offering poor returns. This is because the high yields and short maturities of junk bonds are less affected by interest rates, an increase in the issuing company’s revenue may improve the health of a junk bond even when interest rates stay low.
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Junk bonds example
Five years ago, Business Corporation, LLC, needed a little bit of cash flow, but it didn’t want to issue shares. Instead, it sold bonds with a set 2.5% interest rate that offered purchasers reliable, long-term income. This year, however, Business Corporation isn’t doing so hot: its industry is flagging and its revenue is falling. To raise money, it wants to sell bonds again, but Moody’s has rated them below investment grade, and they’re considered high-risk since it’s not clear that Business Corporation will be able to meet all its obligations. In order to entice investors, the bonds have a 10% interest rate.