Junk Bonds: High Risk, High Yield Explained With Credit Ratings

What Is a Junk Bond?

Junk bonds, often referred to as high-yield bonds, carry higher risk due to lower credit ratings from agencies, compared to investment-grade debt. They represent debt issued by financially struggling companies and offer higher yields to compensate for the increased risk of default. These bonds serve as an indicator of market sentiment: growing interest signifies a willingness to embrace higher risk for the potential of improved returns. Investors can assess the risk by reviewing credit ratings: anything below BB is deemed speculative, or "junk."

Understanding the Mechanics of Junk Bonds

From a technical viewpoint, a high-yield, or "junk" bond is very similar to regular corporate bonds. Both represent debt issued by a firm with the promise to pay interest and to return the principal at maturity. Junk bonds differ because of their issuers' poorer credit quality.

Bonds are fixed-income debt instruments that corporations and governments issue to investors to raise capital. When investors buy bonds, they're effectively loaning money to the issuer, who promises to repay the money on a specific date called the 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 with a 5% annual coupon rate means an investor earns 5% each year. A bond with a $1,000 face or par value would yield $50 annually until maturity.

Why Higher Risk Means Higher Rewards With Junk Bonds

Bonds with a high risk of default by the issuer are junk bonds. These are often issued by start-ups or financially struggling companies. Because of this risk, junk bonds offer higher yields to attract investors willing to take on more risk. Companies are willing to pay the high yield because they need to attract investors to fund their operations.

Using Junk Bonds to Gauge Market Sentiment

Some investors purchase junk bonds hoping for price gains as the issuer's financial situation improves, not just for interest income. They believe improved economic conditions will boost demand for high-yield bonds, even those with lower ratings.

As a result, increased buying interest in junk bonds serves 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. If junk bond prices fall, it often means investors are avoiding risk and choosing safer investments.

Although a surge in junk bond investing usually translates to increased optimism in the market, it could also point 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.

How Corporate Financial Health Impacts Junk Bond Ratings

If a company performs well financially, its bonds may get better credit ratings and attract investors, boosting bond prices. Poorly performing companies often have low or falling ratings. These falling opinions might cause buyers to back off. 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 that bonds issued by companies with positive credit ratings usually pay lower interest rates on their debt instruments as compared to companies with poor credit ratings. Many bond investors monitor the credit ratings of bonds.

The Role of Credit Ratings in Assessing Junk Bonds

Despite their risk, investors can gauge junk bond risks by checking credit ratings, which assess the issuer's ability to repay debt. These ratings impact the bond's market price and interest rate.

Credit-rating agencies measure the creditworthiness of all corporate and government bonds, giving investors insight into the risks involved in the debt securities. Credit rating agencies assign letter grades for their view of the issue.

For example, Standard & Poor's has a credit rating scale ranging from AAA—excellent—to lower ratings of C and D. Any bond that carries a rating lower than BB is said to be of speculative-grade or a junk bond. This should be a red flag to risk-averse investors. The various letter grades from credit agencies represent the financial viability of the company and the likelihood that the contract terms of the bond terms will be honored.

Investment Grade

Bonds with a rating of investment-grade come from corporations that have a high probability of paying the regular coupons and returning the principal to investors. For example, Standard & Poor's ratings include:

• AAA—excellent
• AA—very good
• A—good
• BBB—adequate

"Junk" (Speculative)

As mentioned earlier, once a bond's rating drops into the double-B category, it falls into the junk bond territory. This area can be a scary place for investors who would be harmed by a total loss of their investment dollars in the case of a default.

Some speculative ratings include:

• CCC—currently vulnerable to nonpayment
• C—highly vulnerable to nonpayment
• D—in default

Companies having bonds with these low credit ratings might have difficulty raising the capital needed to fund ongoing business operations. However, if a company manages to improve its financial performance and it's bond's credit rating is upgraded, a substantial appreciation in the bond’s price could happen. Conversely, if a company's financial situation deteriorates, the credit rating of the company and its bonds might be downgraded by credit rating agencies. It is crucial for investors in junk debt to fully investigate the underlying business and all financial documents available before buying.

Understanding the Risk of Junk Bond Defaults

If a bond misses a principal and interest payment, the bond is considered to be in default. 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, making these bottom-level debts even riskier.

Real-World Example of a Junk Bond

Tesla Inc. (TSLA) issued a fixed-rate bond with a maturity date of March 1, 2021 and a fixed semi-annual coupon rate of 1.25%. The debt received an S&P rating of B- in 2014 when it was issued. In October 2020, S&P upgraded its rating to BB- from B+. This is still in junk bond rating territory. A BB rating from S&P means the rating issue is less vulnerable to nonpayment, but still faces major uncertainties or exposure to adverse business or economic conditions.

Also, the current price of the Tesla offering is $577 as of Oct. 2020, much higher than its 2014 $100 face value, which represents the extra yield that investors are getting above the coupon payment. In other words, despite the BB- rating, the bond is trading at very large premium to its face value. This is because the bonds are convertible to equity. Thus, with shares of Tesla soaring 600% over the last twelve months ending Oct. 26, 2020, the bonds are proving to be valuable surrogates for the equity.

The Bottom Line

Junk bonds are high-risk, high-yield debt securities issued by financially struggling companies. While they offer the potential for higher returns, they also carry a significant risk of default, with ratings below investment grade as determined by credit agencies. Understanding these dynamics helps investors make informed decisions about balancing risk and potential rewards. Investors should thoroughly research a company's financial health and market conditions before investing in junk bonds, as these factors heavily influence bond performance.