What Is a Junk Bond?
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promise to pay investors interest payments and principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.
Junk Bonds Explained
Bonds are fixed-income debt instruments that corporations and governments issue to investors in order to raise funds. When investors purchase bonds, they're effectively loaning money to the issuer who promises to repay the money on a specific date or maturity date. At maturity, the investor is repaid the principal amount invested. Most bonds pay investors an annual interest rate during the life of the bond, called a coupon rate.
For example, a bond that has a 5% annual coupon rate means that an investor who purchases the bond earns 5% per year. So, a bond with a $1,000 face value will receive 5% x $1,000 or $50 each year until the bond matures.
A bond that's at a high risk of default by the issuer is called a junk bond. Companies that issue junk bonds are typically start-ups or companies that are struggling financially. Junk bonds carry risk since investors are unsure whether they'll be repaid their principal and the interest payments. As a result, junk bonds pay a higher yield than their safer counterparts to help compensate investors for the added level of risk. Companies are willing to pay the high yield because they need to attract investors in order to fund their operations. Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default.
Junk Bonds and Credit Ratings
Although junk bonds are considered risky investments, investors can monitor a bond's level of risk by reviewing its credit rating. A credit rating is an assessment of the creditworthiness of an issuer and its outstanding debt in the form of bonds. The company's credit rating and ultimately the bond's credit rating impacts the price of a bond and its interest rate.
If a company performs well financially, its bonds will have a positive credit rating and usually attract buying interest from investors. As a result, the bond's price rises as investors pay for the creditworthy bond from the financially viable issuer. Conversely, companies that are performing poorly will likely have low credit ratings and might have difficulty attracting buyers. Companies with poor credit ratings typically offer high yields to attract investors and to compensate them for the added level of risk.
The result is bonds issued by companies with positive credit ratings usually pay lower interest rates on their bonds as compared to companies with poor credit ratings. Many bond investors monitor the credit ratings of a bonds.
Credit-rating agencies measure the creditworthiness of corporate and government bonds to give investors insight as to the risks involved in investing in those bonds. Credit rating agencies assign letter grades for their ratings. For example, Standard & Poor’s has a credit rating scale ranging from AAA (excellent) to C and D. A bond with a rating below BB is considered to be a speculative grade or a junk bond, which means it's more likely to end in default. The various letter grades from credit agencies represent the financial viability of the company and the likelihood the bond terms will be honored.
Bonds with a rating of investment-grade are issued by companies that have a high likelihood of paying the interest and principal from their bonds. For example, Standard & Poor's ratings of AAA (excellent), AA (very good), A (good), and BBB (adequate) are all investment grades.
Any bond that's rated below investment grade is considered speculative. For example, Standard & Poor's speculative-grade is any bond below a BBB rating. Some speculative ratings include CCC (currently vulnerable to nonpayment), C (highly vulnerable to nonpayment), and D (in default). As mentioned earlier, speculative bonds have a high risk of default whereby investors could lose all of their principal invested.
Companies that have bonds with low credit ratings might have difficulty issuing new bonds and raising the money needed to fund business operations. However, if a company manages to improve its financial performance and its bond's credit rating is upgraded, a substantial appreciation in the bond’s price could occur. Conversely, if a company's financial situation deteriorates, the credit rating of the company and its bonds might be downgraded by credit rating agencies.
If a bond misses a principal and interest payment, the bond is considered to be in default. A default is the failure to repay a debt including interest or principal on a loan or security. Junk bonds have a higher risk of default because of an uncertain revenue stream or a lack of sufficient collateral. The risk of bond defaults increases during economic downturns and the bonds with the highest risk of default are junk bonds.
Junk Bonds as an Indicator
Some investors buy junk bonds to profit from potential price increases and not necessarily for the interest income. Investors that are expecting bond prices to rise are betting there'll be an increased buying interest for high-yield bonds due to a change in market risk sentiment. For example, if investors believe economic conditions are improving in the U.S. or abroad might purchase junk bonds of companies that'll improve along with the economy.
As a result, money flows or increased buying interest of junk bonds serve as a market-risk indicator for some investors. If investors are buying junk bonds, market participants are willing to take on more risk due to a perceived improving economy. Conversely, if junk bonds are selling off with prices falling, it usually means that investors are more risk averse and are opting for more secure and stable investments.
Although a surge in junk bond investing usually translates to increased optimism in the market, it could also lead to too much optimism in the market. It's important to note that junk bonds have much larger price swings than bonds of higher quality. Investors looking to purchase junk bonds can either buy the bonds individually through a broker or invest in a junk bond fund managed by a professional portfolio manager.
Junk bonds offer higher yields than most fixed-income securities
Junk bonds have the potential of significant price increases if the company's financial situation improves
Junk bonds or high-yield bonds can serve as a risk indicator of when investors are willing to take on risk or avoid risk in the market
Junk bonds have a higher risk of default than most bonds with better credit ratings
Junk bond prices can fluctuate or exhibit volatility due to uncertainty surrounding the issuer's financial performance
Junk bonds can indicate an overbought market meaning investors are too complacent with risk and may lead to market downturns
Real World Example of a Junk Bond
Tesla Inc. (TSLA) has a bond outstanding that's maturing in March 01, 2021 and was issued with a coupon rate or interest rate of 1.25% in 2014.
Below are the bond's details as of April 10, 2019:
- Price at Offering $100.00
- Offering Date: 02/27/2014
- Coupon Rate: 1.250 %
- Yield at Offering: 1.25%
- Coupon Type: Fixed
- Maturity Date: 03/01/2021
- Coupon Payments: Semi-Annual
- Symbol: TSLA4103351
- CUSIP: 88160RAC5
- Standard & Poor's Rating: B- (as of 05/27/2014)
The current yield offered on the bond for those looking to purchase it stands at over 7%, which is much higher than the original coupon rate of 1.25%. The reason for the disparity is that the bond has a B- rating from Standard & Poor's rating agency. The B- rating means the bond or company has adverse conditions that might impair payment capability. As a result, the higher yield compensates investors for the added level of risk.
The price of bond fluctuates as investors weigh the risks and rewards of owning the bond. Also, macroeconomic conditions impact the overall bond market that ultimately affects the bond's price in the market. The current price is $103 or slightly higher than the $100 face value, which represents the extra yield that investors are getting above the coupon payment. In other words, despite the B- rating, the bond is trading at a $3 premium to its face value, which is likely due to the high yield of 7% being offered.
For reference, the 10-year Treasury yield was issued on March 15, 2019 at a rate of 2.625% making the yield of 7% on the Tesla bond a high-yield bond and far more attractive than current yields. However, Tesla has had financial difficulty over the last few years, making the bond risky as we can see from Standard & Poor's B- rating.