Why Junk Bonds Are High-Yield and High-Risk Investments

Key Takeaways

• A junk bond is generally a corporate bond issued by a company that lacks an investment-grade credit rating from a ratings agency.

• Junk bonds are generally cheaper than normal bonds and offer investors higher interest rates, which can offset what is a greater risk of default.

• The primary potential benefit is higher yields than most other fixed-income debt securities, which companies agree to pay because they need investments to fund their operations.  

Junk bonds are so known for their high yields that that is also what they are often called: high-yield bonds. The other side of that, though, is greater relative risk. Investors who have an appetite for such risk could do well.

But just what is a junk bond? 

Junk Bond Explained

A junk bond is generally a corporate bond issued by a company that lacks an investment-grade credit rating from a ratings agency. In fact, such a lack is chiefly how it differs from regular corporate bonds that governments and corporations issue to investors to raise capital.

In exchange for buying bonds — debts that have been given low credit ratings — investors are promised regular interest payments in addition to the return of their principal. The interest rate is called a coupon rate.

Junk Bond: Risk Tradeoffs

Such bonds are known as high-yield bonds for good reason: they generally are cheaper and offer investors higher interest rates than most bonds.

However, such prospective benefits help offset what is a greater risk of default. And despite the risk, junk bonds remain less likely than some other stocks to produce permanent losses. Why? Because if an issuing company goes bankrupt, it must repay bondholders before shareholders.

So, there are potential investment tradeoffs that should be weighed.

The Role of Credit Ratings

Junk bonds are generally issued by companies that are either startups or are struggling financially and have low creditworthiness.

All corporate and government bonds are measured by a credit rating agency such as Moody’s, Standard & Poor’s, and Fitch, which assigns letter grades for how they view risks. Standard & Poor’s credit rating scale, for example, ranges from the top grade of AAA to lower grades of C and D. All bonds that have a lower S&P rating than BB – BBB is “adequate” — is deemed a junk bond.     

Are Junk Bonds Popular?

The popularity of junk bonds depends on market dynamics as well as the buyers’ appetite for risk. The risk is default, which occurs when a bond has missed a principal and interest payment, usually due to lack of sufficient collateral or unreliable revenue stream. To compound matters, default risk goes up during economic downturns.  

Having said that, the bonds’ relatively low cost and the lure of higher yields are enough for some investors. 

How Does a Junk Bond Work?

Bonds are usually bought in increments such as $1,000 or $5,000 and can trade for the bond’s face value – the amount the debt issuer repays the investor at maturity.

Bond prices are informed by the overall business outlook, average market interest rates, and the company’s financial performance. Note that rising junk bond prices generally signify an improving economy. The opposite is also true.

Bonds viewed as risky are more apt to trade at discounts to their face value, while bonds from issuers that are lower risk trade at premiums to par. 

Take Tesla (TSLA), for example. In 2014, the company issued a fixed-rate bond with a semi-annual coupon rate of 1.25% and a maturity date of March 1, 2021. When it was issued, the debt received a Standard & Poor’s rating of B-. In October 2020, Tesla’s bond rating was upgraded to BB- from B+, which is still in the junk bond range. Still, the BB rating means the bond is believed to be less susceptible to nonpayment, but still faces significant uncertainties or exposure to unfavorable economic or business environments.

In addition, Tesla’s share price rose to $577 in October of 2020, markedly more than its $100 face value, which represents the additional yield investors get on top of the coupon payment.  So, its BB- rating notwithstanding, Tesla’s bond traded at a very big premium to its face value. 

Note that investors who seek to buy junk bonds can do so individually through a broker or through a professionally managed junk bond fund.

Are Junk Bonds a Good Investment?

As with all investment opportunities, there are potential benefits and drawbacks to purchasing junk bonds. 

The primary potential benefit is higher yields than most other fixed-income debt securities, which the companies are willing to pay because they need investments to fund their operations.  

Also, if the company’s financial circumstances improve, the prices of junk bonds could go up. Further, such bonds serve as a risk indicator, in that they demonstrate when investors are willing to take on or avoid marketplace risk.  

The major junk bond drawback is risk. Investors cannot be certain that their principal will be repaid and that they will earn interest payments.

Another disadvantage is potential price volatility owing to uncertainty regarding the company’s financial state. Also, active junk bond markets can lead to market downturns as they can indicate an over-complacency with risk.   

Diversifying Your Portfolio Through Junk Bonds

Despite the risk, investing in junk bonds can be a good way to diversify one’s holdings, which is key to successful investing over time. A diversified portfolio, which spreads capital over a variety of investments and asset classes, helps to mitigate overall risk and volatility.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Junk bonds do have a higher default rate than higher-quality bonds and larger price swings. However, they also cost less and carry the potential for greater returns. Thus, potential investors must first weigh the tradeoffs.

Note that such bonds, as well as alternatives, can help diversify investment holdings, which can lessen overall portfolio risk over time.