Junk Bond: Definition, Process & Benefits

KEY TAKEAWAYS

• Bonds that have been granted a poor credit rating, or below investment grade, are referred to as junk bonds.
• These bonds are therefore riskier because there is a greater likelihood that the issuer will have a credit event or default.
• Junk bonds are sometimes known as high-yield bonds since investors are rewarded for taking on more risk with higher interest rates.

What Are Junk Bonds?

Junk bonds are bonds that have a higher default risk than the majority of bonds issued by governments and corporations. A bond is a debt or promise that, in exchange for being purchased, would pay investors interest payments as well as the return of their principal investment. Junk bonds are bonds issued by struggling businesses that run a significant risk of default, failing to make interest payments, or failing to return the investors’ principle.

Due to the necessity for a greater yield to assist offset any default risk, individual junk bonds are sometimes referred to as high-yield bonds.

How Do Junk Bonds Work?

Bonds can trade for above or below par, which is equal to the bond’s face value, and are often only purchased in very significant amounts. The face value is what the bond investor receives from the debt issuer when the bond matures.

The business outlook, stock market-wide average interest rates, and a company’s financial performance all affect a bond’s trading price. Bonds from higher-risk corporations typically trade at premiums to par, whilst bonds from lower-risk companies typically trade at discounts to the bonds’ face value.

Notably, the stock price of a corporation has little impact on bond prices. Bonds are only loans to firms, whereas stocks represent ownership in a company. A bond’s value is essentially its face value at redemption plus the interest it will earn.

Rising junk bond prices typically signal an economy that is doing better as a whole. Prices for junk bonds are typically on the down when the economy is doing poorly or getting worse.

Who Invests in Junk Bonds?

Any investor that is looking for a speculative opportunity at gaining a higher income may invest in junk bonds. 

However, junk bonds aren’t suitable for every investor. They are riskier than investment-grade bonds due to the possibility of default and their illiquidity. Losses can be painful even if the investor is typically rewarded for this risk with a better return.

How to Invest in Junk Bonds

There are a few ways to start if you want to add junk bonds to your financial portfolio. For most individual investors, purchasing a junk bond mutual fund or electronically traded bond fund (ETF) is the best course of action. With just one purchase in your brokerage account, you can have exposure to a variety of junk bonds by buying the following:

Individual bonds

You might be able to use your brokerage account to directly purchase individual bonds if you have the money to do so. An individual bond, however, is not a good diversification option and is not recommended for the majority of investors.

Mutual funds

Bond mutual funds are yet another accessible entry point for individuals, or for retail investors into the bond markets. They operate similarly to ETFs aside from the fact that they are bought and traded in overnight batches.

ETFs

These funds let you access a variety of bonds at once and can be purchased and sold like stocks. Before purchasing, consider the costs, past success, and ratings of the fund.

What Are the Benefits of Investing in Junk Bonds?

There are a number of benefits to investing in junk bonds. These include:

• Compared to most other fixed-income debt securities, junk bonds offer greater yields.
• Should the company’s financial status improve, junk bonds could see huge market price gains
• When investors are inclined to take on a certain current level of risk or avoid it in the stock market, junk bonds act as a risk indicator.

What Are the Risks of Investing in Junk Bonds?

There are also some downsides to investing in junk bonds. These include: 

• Compared to most bonds with better credit ratings, junk bonds have a higher default level of risk.
• Because of the ambiguity surrounding the bond issuer’s financial current performance, junk bond values might fluctuate.
• Market downturns may result from investors being overly complacent with risk due to overbought conditions, which are indicated by active trash bond markets.

What Are the Examples of Junk Bond Companies?

A good example of a junk bond company is Netflix. The streaming service falls into the category of growth-oriented companies. The corporation issued junk bonds as part of its strategy to finance internal film and television production for years in order to pay for new content creation for its streaming service. 

As Netflix has grown closer to generating positive free cash flow, the value of its bonds, which also trade at a premium, has increased modestly. 

Summary

Although junk bonds make up a sizable portion of the bond market, your portfolio shouldn’t contain a sizable portion of them. It’s acceptable for many individual investors to fully avoid trash bonds. Others should only make up a small amount of your diversified portfolio, and the best way to buy them is through diversified ETFs.

You might think that a mound of garbage in your cellar is undesirable for your financial portfolio. As always, when investing, it’s critical that you understand what you’re doing. Every investment should be the result of careful consideration and informed opinions.