Brief overview:  A junk bond is a higher-risk bond that has a speculative appeal as they can offer much higher yields. However, companies that issue junk bonds typically have a poor credit rating, and although the price appreciation of a junk bond is substantial if the company manages to turn itself around, it isn’t always able to do so.

Full overview: Junk bonds attract investors with their high yields and whopping profit potential. However, there’s no free lunch in the markets, and investors who decide to purchase junk bonds may lose their entire investment if the issuing company defaults on its debt.

Here, we’re going to take a closer look at junk bonds, their main characteristics, pros and cons, and how they can be used to gauge the overall risk sentiment in the markets.

What is a Junk Bond?

A junk bond is a high-yield bond that carries a higher risk of default than other investment-grade bonds. Junk bonds are usually issued by companies that have a history of not paying their interest payments and that are struggling financially, which is why junk bonds have higher interest rates to offset any risk of default.

Junk bonds have a low credit rating and are considered below investment grade. Historically, their average yields have been around 5% above the yields for similar US government bonds.

In essence, junk bonds represent debt issued by an entity with the promise of interest payments and the return of principal at maturity. In this regard, junk bonds are quite similar to regular corporate bonds, with the only difference that the company that issued junk bonds has a low credit quality and a higher risk of default.

That’s why junk bonds need to carry higher interest rates to account for the higher risk of default.

Companies that issue junk bonds are usually start-ups or companies with low credit ratings that are willing to pay higher yields to attract investor capital. Investors are compensated by higher interest rates for investing in those companies.

Brief History of Junk Bonds

Junk bonds rose in popularity in the late 1970s, when small and young companies started issuing high-yield bonds to finance their growth and business operations and became a common investment tool in the early 1980s.

At the time, Michael Milken who was an ambitious trader at the investment bank Drexel Burnham Lambert recognised the financial opportunity that came with junk bonds and started to advise companies and investors to take full advantage of them.

Milken, who later became known as the “Junk Bond King”, advised smaller companies to issue junk bonds for hostile takeovers. Those companies would issue debt without underlying assets and use the cash to bid on another target company.

The company would then use the assets of the newly-acquired company to repay its debt obligations. The popularity of junk bonds fell significantly in the late 1980s with rising default rates among small companies.

Pros and Cons of Junk Bonds

Here are the main pros and cons of investing in junk bonds:

Pros:

• Junk bonds are high-yield bonds that offer higher potential returns than most other types of bonds
• If an investor picks the right junk bond and the issuing company stabilises financially, junk bonds offer the potential of enormous profits
• Other market participants can follow junk bonds to get a hint of the current risk appetite in the markets

Cons:

• The main disadvantage of junk bonds is their risk. They have a higher risk of default than most other fixed-income securities
• Junk bonds can be quite volatile, especially in times of uncertainty regarding the issuer’s performance

Junk Bonds and Risk Sentiment

The performance of junk bonds can also be used to gauge the overall risk appetite in the markets. Some investors don’t buy junk bonds for their interest payments, but to speculate on price movements. Since junk bonds can be quite volatile, they can experience large price increases in times when the economy is doing well.

Of course, the opposite is true when the economy is struggling – Junk bonds are usually the first to fall in price as investors start avoiding riskier assets.

That’s why some investors base their investment decisions partly on the performance of junk bonds. When high-yield bonds rise, this can be interpreted as increased risk appetite in the markets due to improving economic conditions.

As a result, some other markets may also follow and see higher demand, such as equities for example. On the other hand, falling junk bonds may indicate reduced risk appetite and signal higher demand for safer investments, such as government bonds for example.

Checking the Issuer’s Credit Rating

The issuer’s credit rating has a large influence on the price of junk bonds. When financials of the issuing company improve, the company’s bonds will have better credit ratings and attract new investors. On the contrary, when the underlying company’s financials deteriorate, its bonds will have lower credit ratings.

This means that the company will have to offer higher interest rates on its bonds in order to compensate for the higher investment risk and attract new investors.

A credit rating is simply the assessment of the issuer’s creditworthiness by a rating agency, such as Fitch or Standard & Poor’s. Companies with better credit ratings are able to issue bonds with lower interest rates as their risk of default is lower. Companies with high investment-grade credit ratings have a high probability of repaying the principal of the bond and its interest payments. According to S&P’s ratings, those companies could have a credit rating of AAA (excellent), AA (very good), A (good), or BBB (adequate).

If the company drops below those ratings, its bonds are considered junk bonds. Those ratings include CCC (currently vulnerable to nonpayment), C (highly vulnerable to nonpayment) and D (in default.) Investors who are invested in those bonds face a high probability of a total loss of their investment.

Companies with low credit ratings may have problems to raise additional capital to fund business operations, but if their financial stability and credit rating improves, their bonds could face a significant rise in value.

Junk Bonds and the 2007-09 Financial Crisis

In the early 2000s, large banks started to repackage high-yield bonds into collateralised debt obligations (CDO), which initially raised the credit rating of other senior tranches of the debt. As a result, the newly-created CDOs met the minimum credit requirements of large institutional investors, such as pension funds, despite the large risks of the underlying high-yield debt.

Subprime mortgage loans were also part of those CDOs, increasing the risks of holding such an instrument. When assets of such dubious value begin to lose market liquidity and fall in value, they’re referred to as “toxic debt”.

Toxic debt led to the liquidation of several investment banks during the 2007-09 subprime mortgage crisis and the US Treasury announced in 2009 that the government will buy toxic assets from the banks’ balance sheets in order to prevent a systemic crisis in the industry.

Final Words

Junk bonds are high-yield bonds with a higher default risk than most other fixed-income securities. To compensate for the higher risk, junk bonds offer relatively high-interest rate payments that, historically, have reached around 5% above those for similar US government bonds.

Junk bonds rose in popularity in the early 1980s when young companies started issuing debt to finance their growth and business activities. They skyrocketed in popularity through the 80s with Michael Milken, an investment banker who recognised the huge financial opportunity in junk bonds.

If you’re thinking of trading junk bonds or including them in your portfolio, make sure to check the issuing company’s credit rating and financial prospects. Improved financial performance of the issuer may lead to a substantial rise in the junk bond’s price but bear in mind that the risk of default is also higher than with other fixed-income securities.