Junk bonds are a type of bond that carries a high risk of default.
They carry a stark contrast with government-issued and some corporate bonds, which are relatively safe.
What sets “junk bonds” apart is the picture of the issuing companies.
The term normally refers to bonds issued by companies in financial trouble, struggling to make their interest payments, and/or running a high risk of default. The former, of course, implies that these companies are having trouble paying both interest and principal to investors.
On the other side, junk bonds are also referred to as “high-yield bonds” because the higher yield is meant to offset the risk of default.
So, let’s go over how to protect yourself while investing in bonds, including:
Given the risk involved in companies offering these bonds, it should be no surprise that they do not come with collateral.
Corporate and (some) government bonds may be secured or unsecured.
Federal bonds are unsecured, but corporate and municipal bonds often are. That means if the company fails to repay both principal and interest, the collateralized assets can cover debt repayments. Secured bonds further reduce the risks of bond investing.
The advantage of junk bonds is the higher yield they offer to offset their high risk.
In two words: increased rewards.
In the bond market, higher risk equates to higher yields. The companies issuing these bonds are either too young or struggling for some other reason. So, their bonds pay a higher yield to compensate for the risk.
Even when you zoom out and consider bonds against all other fixed-income debt securities, their returns are relatively high.
Another aspect of this is that in the case that the company’s financial situation improves, you benefit greatly as a holder of their bonds. The bond’s price increase could thus benefit you even more. So, considering the company’s prospects is an important part of the decision.
Risk is of course the main disadvantage of this type of bond.
If the financial situation of the company deteriorates or simply fails to improve, you’re one of the losers in that situation.
These bonds are defined by their risk, but this risk includes instability in this case. The instability resulting from the company’s financial challenges often means price volatility.
The “junk bond” label does not only apply to obscure, nameless companies.
You would probably recognize several company names in the long list of these bonds on the market.
Among the companies that are rated below investment grade, there are names such as:
In fact, 95% of US companies with revenues exceeding $35 million annually are rated as “non-investment grade”. That means the vast majority of publicly listed companies are issuing junk bonds.
Read this before you invest! 4 Benefits & 7 Ways to Conduct Due Diligence in Picking Stocks
Junk bonds can be a useful instrument for investors willing to engage in riskier strategies for the potential of higher gains.
However, they are defined by their higher level of risk, which implies a lack of security and a higher risk of default.
As always, it is up to each investor to scrutinize each potential investment. Junk bonds are no exception, but in fact justify greater scrutiny.
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