Junk Bond Definition: What Are Junk Bonds?
May 3, 2017
Investing in Junk Bonds
Junk bonds are a great way to generate a high rate of return on your investments. What’s more, the risk associated with such investments is not as high as you may think.
The simplest way to describe junk bonds is by making a comparison to high-yield dividend stocks. With these stocks, a high rate of return is earned via the dividend. Junk bonds are similar in how the income is received; you simply own the investment and collect. That said, there are also quite a few differences between the two as well.
The focus of this article is providing all the information you need to know about junk bonds so your investment portfolio can benefit. Topics will include junk bonds’ advantages and disadvantages, reasons for a high yield, and what impacts the bond.
What Is a Bond?
A bond is a loan that is given by an investor to a corporation with a few key features associated with it. Necessary information for the bond is determined before it is made available for trading, which is detailed below.
The coupon payment, or interest payment, is the payment that is made to investors on a semi-annual basis. This remains the same over the life of the bond.
The coupon rate, or interest rate, is the percentage that is paid to investors on the issue date. If you happen to purchase the bond at a value other than face value, then the coupon rate will be recalculated.
The face value is the value that the bond is issued at, which doubles as the maturity value. Over the life of the bond, its price will fluctuate.
The maturity date is a predetermined date at which point the bond ends and the money should be returned to the investor. This is also the date that the face value will be returned to investors.
What Are Junk Bonds?
Junk bonds are very similar to traditional normal bonds (known as investment-grade bonds), also being a loan given to a corporation. Both bonds also have a maturity date, a principal amount that will be paid at maturity, and a coupon payment.
Below are the differences between a normal bond a junk bond.
Investment-Grade Bonds
An investment-grade bond would be applied to a low to medium borrower that has a low chance of defaulting and a high probability of returning the money. Given the lower amount of risk, the return from the interest payment will also be low.
All this information is based on a credit rating applied to the company. For a business to be considered investment-grade, the credit rating would have to be between AAA/Aaa and BBB-/Baa3.
There are different credit agencies that set the letters associated with a rating on a bond. Just like grade school, AAA/Aaa would be considered the best bonds and going lower down the alphabet would mean a lower grade.
Junk Bonds (High-Yield Bonds)
Compared to investment-grade bonds, the interest rate on junk bonds is higher. There is also a greater percentage of a default occurring, which is why investors receive a higher interest rate. A junk bond would have a rating of Ba1/BB+ and lower.
Junk Bonds Advantages and Disadvantages
Junk bonds could be great for your investment portfolio for the following reasons:
1. Higher Income Return
There will be a higher interest rate associated with the investment compared to investment-grade bonds and other fixed-income assets.
2. Outperformance in a Recession
In a recession, the stock market tends to see a negative return. However, the return on junk bonds in a recession should be positive. This is because investors are looking for safety on the capital investment and a steady income stream.
3. Steady Income
A company is obligated to pay debtholders before equity investors. If a company does pay such a a dividend, it risks future cuts, whereas the interest payment will remain constant.
4. Top Priority on the Corporate Structure
If a company happens to go bankrupt, then bond investors would receive a payment before common shareholders, assuming the remaining cash allows it.
5. Capital Appreciation
Income is one way to generate a return, while another is through a bond’s capital appreciation. Bond prices change day-to-day as a stock does, so there is always the possibility of purchasing a bond below face value. A capital gain is possible if held until maturity or the bond is sold at a higher price.
There are also downsides to owning a junk bond, which are as follows:
1. Less Liquid
Compared to investment-grade bonds, junk bonds have less daily volume. This also means that the spread between buying and selling a junk bond is greater, and doing so after the issue date may be difficult.
2. Prices Are Affected by Interest Rates
Sometimes, the trading price is not affected by the performance of the company, but rather by the direction of interest rates. As interest rates move higher over time, the price of the junk bond will decrease. This is out of the control of investors.
3. Higher Default Risk
Since a bond is paying a higher interest rate, there is greater risk than with investment-grade bonds. Even though bond investors are at the top of the corporate structure, there could be a long wait for a payout. In addition, that payout may only be a percentage of the actual investment.
4. Credit Rating Changes
If there are changes in a company’s corporate structure or earnings, it could result in a downgrade in its credit rating. If that happens, potential investors may steer clear of the existing bonds, while current investors may lose some capital value.
Why Do Junk Bonds Offer a Higher Yield Than Other Types of Bonds?
Before hitting the market, all bonds are rated by a credit agency such as Moody’s Corporation (NYSE:MCO), Standard & Poor’s, and Fitch Group Inc.
The way that each bond is rated is based on the company’s financial statements and earnings. If the balance sheet and earnings power are strong, then it would most likely be labeled as an investment-grade bond. In that case, a lower interest rate would be paid to investors since earnings and the financial statements would support the principal at maturity.
Companies that have a large debt load and weak earnings power would be rated lower and could be classified as a junk bond. This would result in a high interest rate, since investors would be aware of the risk going in.
Another factor is how the business environment is expected to perform in the future.
The reason that the financial statements are important is that investors don’t want a company to be carrying the burden of too much debt. Earnings power is looked at to ensure how the debt interest and principal will be paid.
An interest rate will be determined and made fixed before the bond is available for purchase. However, a company’s credit rating can change based on the current balance sheet, changes in earnings power, and/or a better business outlook.
It is possible for a company to have multiple bonds that are outstanding, which could mean that each one has a different interest rate due to its credit rating at the time of issue.
Are Junk Bonds Riskier Than High-Dividend Stocks?
Both junk bonds and high-dividend stocks would be put into the same category based on their asset class. Read on for more information.
A High-Dividend-Paying Stock
- A company will use its earnings to pay out a dividend. If there is not enough to do so, the dividend may be cut or stopped entirely.
- A dividend cut or elimination may cause more selling of the shares than buying, lowering the share price over time.
- When it comes to selling the shares in the future, there is no set price that will be paid out. This will be based on the trading price of the stock at the time of the transaction.
- If the company happens to file for bankruptcy, shareholders may receive nothing. This is because, as explained earlier, common shareholders would be considered at the bottom of the totem pole when it comes to a company’s ownership structure.
A Junk Bond Investment (High-Yielding Bond)
- The interest payment must be released before the dividend.
- Investors that possess company bonds are considered the top priority. Upon bankruptcy, money left over would go to bond investors first.
- If the bond is held until the maturity date, then the face value of $1,000 would be received. In other words, investors will know how much they will receive and when.
- Bonds are uncorrelated to the stock market, which means that they could generate higher returns in a poor market than stocks.
- Bond sellers can still earn interest before the actual payment date, as explained further below. Dividend investors, on the other hand, receive either nothing or the whole dividend payment.
Remember that no matter which you choose, due diligence is still required to ensure that the investment is appropriate for you and stays that way.
How to Buy Junk Bonds
There are a few ways to own junk bonds in your investment portfolio. Below are the possible methods.
1. Broker
If you are managing your own investment portfolio with an online broker, buying junk bonds is very simple, thanks to the Internet.
You can always use the research tools within your brokerage account to find a potential investment. Or if you already know your preferences, then just place the order.
Once you find a desired junk bond, then a purchase order can be placed. A purchase order is the quantity you intended to buy and the purchase price. The reason that the purchase is entered this way is that many brokers do not take market orders on bonds. This also protects investors because the exact cost is known in advance and nothing will be purchased above their budget.
2. Exchange-Traded Funds
If you want exposure to more than one junk bond, then exchange-traded funds (ETFs) are a great method.
Just one ETF in your investment portfolio means owning 25, 50, or even hundreds of junk bonds. This means a lot less risk within the portfolio.
There is also a portfolio manager that looks after the investment decisions and capital allocation of the ETF.
3. Purchase from the Company
If you have a company in mind and don’t want to use a broker, then the junk bond could be purchased through the company itself. The advantage of this is that there is no need to pay a commission.
The one thing to keep in mind, however, is that not all companies offer this method. Therefore, the default outcome may be a broker.
Important Things to Know Before Buying a Junk Bond
When purchasing a junk bond, the commission is built into the purchase price. However, it is broken down so investors know how much they are paying for everything.
Also, depending when the purchase is made, there may be an interest payment made to the seller. The factors that come into play here are the interest rate and the number of days that the bond is held.
A interest payment is made every six months by a company to bondholders. For example, let’s say a bond has a face value of $1,000 (interest rate 13%) and makes the interest payment on January 11 and July 11 of every year. Now, let’s say the bond was sold 30 days after the January 11 payment. This would result in interest that must be paid to the purchaser of the bond for 30 days.
Here is the calculation for the interest payment that will be paid of the buyer of the junk bond. Since the interest payment is made every six months, it must be divided by two:
Number of days that the seller would receive the interest payment = 30 days
Interest payment paid on buying of junk bond = (13% x 30 days) x $1,000 (Face Value) ÷ 360 = $10.83
So in this case, $10.83 would be received by the seller for the $1,000 face value.
Why Would a Person Invest in Junk Bonds?
Taking the time to understand the company before making an investment could result in a high rate of return. This is just one of the reasons to consider junk bonds.
Junk bonds also lower a portfolio’s overall risk. A fully diversified portfolio would include both equities and bonds, with junk bonds making up a part of the latter. Times of volatile stock markets could result in seeing a higher return with junk bonds, since, again, bonds are uncorrelated to the market.
