Junk bonds are sometimes known as high-yield bonds since they require a greater yield to help offset the risk of default.
What exactly is a trash bond?
Junk bonds, often known as high-yield bonds, are hazardous investments with a higher risk of default but higher yields. Junk bonds, unlike lower-risk investment-grade bonds, aren’t usually good long-term investments and can rapidly lose money if the investor isn’t diligent.
What types of bonds are considered junk?
Junk bonds are those issued by corporations with a credit rating of BB or lower from S&P or Fitch, or Ba or lower from Moody’s. A fallen angel bond is debt that was originally issued by an investment-grade company but was later downgraded by a credit rating agency to “junk” status. This might happen if the company starts losing money, takes on too much debt, or operates in a declining industry.
Why are trash bonds so dangerous?
- Because junk bonds have a lower credit rating than investment-grade bonds, they must provide higher interest rates to entice investors.
- Standard & Poor’s rates junk bonds as BB or lower, whereas Moody’s rates them as Ba or lower.
- The bond issuer’s rating shows the likelihood of default on the debt.
- If you want to invest in junk bonds but don’t want to pick them out yourself, a high-yield bond fund is a good option.
Why are trash bonds so appealing?
- When compared to standard investment grade bonds, they pay out more: This is the most important one. It’s all about the money. Simply put, because these bonds are not investment-grade, the company issuing them must provide a larger return on investment. This means that if a trash bond matures, it will always pay out more than an investment-grade bond of comparable size.
- If the bond’s issuing company’s credit rating improves, the bond may appreciate as well: When it’s evident that a company is doing everything it can to enhance its credit rating, investing in high-yield bonds before they reach investment-grade status can be a great way to boost returns while maintaining the safety of an investment-grade bond. Investors frequently conduct extensive research into companies that provide high-yield bonds in order to identify “rising stars” in the bond market.
- When a firm fails, bondholders receive payment before investors. Bondholders will be paid out first before stockholders following the liquidation of assets if a business is dangerous but you still want to participate in it.
Are garbage bonds a better investment than stocks?
- High-yield bonds provide stronger long-term returns than investment-grade bonds, as well as superior bankruptcy protection and portfolio diversity than equities.
- Unfortunately, the high-profile demise of “Junk Bond King” Michael Milken tarnished high-yield bonds’ reputation as an asset class.
- High-yield bonds have a larger risk of default and volatility than investment-grade bonds, as well as more interest rate risk than equities.
- In the high-risk debt category, emerging market debt and convertible bonds are the main alternatives to high-yield bonds.
- High-yield mutual funds and ETFs are the greatest alternatives for the average person to invest in trash bonds.
Is it worthwhile to invest in junk bonds?
Junk bonds are corporate bonds that are below investment grade and have a higher risk and yield than other corporate bonds. For some investors, the additional risk is well worth it in exchange for the potential higher rewards. Others, on the other hand, may prefer to avoid these riskier investments.
Junk Bond Pros
- Junk bonds have a higher profit potential than regular bonds. Junk bonds have higher yields than investment-grade bonds due to the heightened risk.
- If an issuer’s performance improves, bonds may gain value. When a corporation is actively paying down debt and improving its performance, the bond’s value might rise as the rating of the issuing company rises.
- Individual stocks are less dependable. Individual stocks may be riskier than investment-grade bonds, although they may not be as risky as individual stocks. When a firm goes bankrupt, bondholders are paid first, followed by investors.
Junk Bond Cons
- The default rate on junk bonds is greater. Junk bonds, on the other hand, have a larger risk of default than investment-grade bonds. In 2020, the default rate for junk bonds was 5.5 percent, according to S&P Global Ratings. Investment-grade bonds, on the other hand, have a default rate of 0.00 percent.
- Liquidity issues. Liquidity concerns with high-yield bonds might make it difficult to sell them for cash when you need it.
- When credit ratings are reduced, the value of junk bonds can plummet. Junk bonds may lose their value. If a company’s credit rating falls much further, the bond’s value will plummet.
Junk Bond Examples
Junk bonds are often associated with smaller enterprises or companies in financial distress. They are, however, frequently issued by well-known companies with long histories, as well as new companies with no track record. Coinbase and Crocs are two recent examples.
Coinbase
Coinbase is a cryptocurrency exchange that saw a surge in demand in 2020 and 2021 as more people purchased cryptocurrencies such as Bitcoin and Dogecoin. In April 2021, Coinbase became public, and in September, it saw a surge in demand for a large junk bond sale. Coinbase’s initial bond offering was for $1.5 billion in seven- and ten-year notes, but demand was so high that it was increased to $2 billion.
After the sale, Moody’s assigned Coinbase a Ba2 junk grade, citing a “uncertain regulatory environment and fierce competition” for the non-investment grade rating. While Coinbase has a leading crypto franchise, its profits are almost entirely dependent on highly volatile cryptocurrency trading, according to Moody’s.
Crocs
Crocs, the company known for its comfortable but obnoxious clogs, said in August 2021 that it will issue $350 million in junk bonds to support stock buybacks. Crocs is rated Ba3 by Moody’s, only behind Coinbase’s Ba2 speculative-grade rating.
Crocs has a well-known brand, a dominant position in the clog market, and reasonable liquidity, according to Moody’s. However, the company’s restricted product focus (clogs) and the high degree of competition in the footwear sector are cited as factors for it not receiving a higher ranking. Furthermore, it went back to a time before it straightened up its operations, when profits were inconsistent.
Is BBB a bad investment?
Ratings firms investigate each bond issuer’s financial condition (including municipal bond issuers) and assign ratings to the bonds on the market. Each agency follows a similar structure to enable investors compare the credit rating of a bond to that of other bonds. “Investment-grade” bonds have a rating of BBB- (on the Standard & Poor’s and Fitch scales) or Baa3 (on the Moody’s scale) or higher. Bonds with lower ratings are referred to as “high-yield” or “junk” bonds since they are deemed “speculative.”
Is B superior to BBB?
Standard & Poor’s and Moody’s employ separate designations to indicate a bond’s credit quality rating, which consist of the upper- and lower-case letters “A” and “B.” Investment grade is defined as “AAA” and “AA” (high credit quality) and “A” and “BBB” (medium credit quality). Bonds with credit ratings below these categories (“BB,” “B,” “CCC,” and so on) are referred to as “junk bonds” because they have a low credit grade.