Corporations often need to raise money to expand, and issuing bonds is one way to do so. However, some companies are stronger that others, and are more likely to be able make the interest payments on the bond, and return the principle at maturity. Weaker companies, on the other hand, are at greater risk of defaulting on the agreement, and the higher risk carries with it a higher interest rate. These higher risk/higher reward issues are commonly called “junk bonds.”
Who decides which bonds are junk? Rating agencies like Moody’s and Standard and Poors are two prominent examples. Agencies consider a number of factors when deciding how capable a company is of making interest and principle payments on a bond. These include how much cash a company has on its books and how easily other assets could be turned into cash in a pinch; the amount of debt that the company owes; how profitable the company is and whether the level of profitability is trending higher or lower, and a variety of other criteria.
Only companies under strain are forced to issue junk bonds. This is where the risk lies. If a company is already swimming in debt, is unprofitable and has little cash to get it through a difficult period, buying a bond it has issued may be a mistake. However, a savvy investor may be able to find junk bonds that are sound investments. Even the strongest and most consistent companies in the world falter on occasion. If the problems are merely temporary a new product flops, a union strikes etc. it might be an opportunity. The rewards could be considerable.
Since troubled companies are at greater risk of defaulting on their payments, they must agree to pay a higher interest rate. If they did not, they simply would not find investors to buy their bonds. Junk bonds are more formally known as “high-yield bonds,” but how much higher are the returns? In some cases, yields may be 4 or 5 percentage points higher than investment grade bonds. This is a sizable premium, and makes junk bonds potentially very attractive.
How often do junk bonds default on their payments? Over the past twenty years high-yield issues have defaulted 2.8% of the time.(1) Though not alarmingly high, this figure is not as small as it seems, and inexperienced investors are wise to tread carefully. Many investors may be more comfortable letting experienced professionals assess the risks and rewards of junk bonds. There are innumerable mutual funds specializing in junk bonds, allowing the average investor a chance to participate in high-yield issues without having to be an expert.
Junk bonds are a potentially attractive investment, though higher returns carry with them higher risk. These risks are not trivial: investors could potentially lose all of their investment in a junk bond. However, many companies struggle temporarily, and are forced to issue bonds with higher yields during dark times, even if the future is likely to be brighter. These cases represent opportunities for both average investors and more seasoned ones alike.