Junk Bonds: Should You Invest in High Yield Bonds?

If you own high-yield bonds, chances are junk bonds have found their way into your portfolio. Investing in junk bonds can be a great way to diversify your portfolio and increase returns, but it also comes with some risks.

With the potential for higher returns come more significant risks, such as the risk of default or bankruptcy of the issuer. This means you could lose all of your investment if things don’t go according to plan. Just because they pose greater risk doesn’t mean you shouldn’t invest in them. Investing in junk bonds can be a smart move for investors looking to maximize their return on investment (ROI) while minimizing risk. In this article, we’ll explore what junk bonds are, how they work, and whether they’re right for you.

What Are Junk Bonds?

Junk bonds, also known as high-yield or speculative-grade bonds, are debt securities with low credit ratings. These bonds typically have higher yields than traditional corporate and government bonds, such as treasury bonds. Because they carry an increased risk of default, junk bonds offer a higher interest rate than investment-grade bonds. When you buy a junk bond, you’re lending to the bond issuer in exchange for interest payments throughout the bond’s life until it matures. However, not all companies keep their promise. This is where bond ratings come into play.

Bond ratings are letter grades issued by credit rating agencies such as Standard & Poor’s (S&P), Moody’s Investors Service, and Fitch. Such ratings measure the perceived risk of the bond issuer’s ability to make interest payments and repay the principal amount at maturity. Bonds rated BBB up to AAA are considered investment-grade bonds, least likely to default. On the other hand, bonds with a rating below BBB are called junk bonds, meaning they have a high likelihood of default. Companies that issue junk bonds are typically struggling financially.

How Do Junk Bonds Work?

As mentioned earlier, junk bonds carry more risk because issuers are usually lower-rated companies or businesses with a greater likelihood of defaulting on payment. Generally speaking, the higher the risk, the higher its yield. For example, junk bonds may offer yields up to 10% or greater, whereas investment-grade bonds may only offer yields in the single digits. You can purchase junk bonds directly from a broker or indirectly through mutual funds, exchange-traded funds (ETFs), and other pooled investments. Bonds typically trade above or below the par of the face value of the bond.

The market price of bonds can vary from their face values based on factors such as the current interest rates, inflation, and the issuing company’s creditworthiness. Therefore, a bond may trade at a premium (higher than its face value) or at a discount (lower than its face value). Bonds with an added risk tend to trade at discounts, while bonds with lower risk trade at a premium.

Why Do Investors Buy Non-Investment-Grade Bonds?

Investors buy junk bonds for various reasons, including the potential for higher returns. Since lower-rated companies typically issue these bonds, they compensate investors with higher yields than other bonds, which often pay just a few percent in interest. This can be especially appealing to investors looking to increase their returns without taking on too much risk.

Additionally, junk bonds offer more diversification within a portfolio. By investing in different types of securities in various sectors, investors can reduce their overall uncertainty. Investing in junk bonds can also provide exposure to a higher-risk asset class, such as emerging markets and commodities, which have the potential for greater returns over time.

Non-investment grade bonds can also provide an attractive hedge against changes in junk bond market conditions or economic downturns. Suppose there’s a period of economic recession or junk bond market volatility. In that case, a high-yield bond may remain competitively priced while other investment vehicles become too volatile or suffer losses due to unpredictable events. As such, they can provide stability and protection during uncertain times.

Junk Bond Examples

Junk bonds can be found in various sectors, from energy to technology and retail. Below are some examples of companies that have issued junk bonds:

• Ford: While Ford has been rated an investment-grade bond in the past, it lost its rating in 2020 and became a junk bond. Amid the COVID-19 pandemic and the global collapse of the economy, Ford lost its “Rising Star” status and became a junk bond. Since then, Ford began issuing non-investment grade bonds, which trade at a premium because of the company’s robust legacy.
• Netflix: As a growth-oriented company, Netflix offered free streaming services to its customers for an extended period, resulting in negative free cash flow. The company started issuing junk bonds, which traded at a premium, to raise cash to fund its in-house production of movies and TV shows. The value of Netflix bonds has significantly increased, earning the company a “Rising Star” status. The company’s improving low credit rating will likely see Netflix achieve an investment-grade status in the future.
• Tesla: Tesla received an S&P rating of B- in 2014 after issuing a fixed-rate bond with a maturity date of March 1, 2021. Its focus on growth saw Tesla get an S&P rating upgrade to BB- from B+ in October 2020. The company is slowly making progress toward becoming an investment-grade bond.

How To Buy Junk Bonds

Investors can buy junk bonds using two common ways:

Buy Individual Bonds

Purchasing individual junk bonds is a popular method of investing in high-yield debt securities. You can buy individual junk bonds through several channels, including investment banks, brokerages, and even directly from the issuer.

When purchasing individual bonds, you should consider the issuer’s overall financial objectives, risk tolerance, and liquidity needs before investing in these instruments. It’s also essential to understand the issuer’s creditworthiness and review the terms of any bond being purchased. However, having individual junk bonds in your portfolio is very risky, as there’s a high likelihood of losing money.

Invest in Bond Funds

If you want to jump into the world of junk debt investing but don’t know the best bonds to pick, investing in bond funds may be a great option. Most of these funds are actively managed by a professional manager, meaning you won’t have to pick them yourself.

Junk bond funds are mutual funds composed of bonds from various issuers. By pooling together a variety of bonds, you can diversify your portfolio and lower the risk associated with investing in individual bonds. When you purchase a junk bond fund, you essentially don’t own the underlying bond but instead a proportionate piece of the fund itself. Since bond funds are highly liquid, you can sell at any time.

Pros and Cons of Junk Bonds

Investing in junk bonds is a great way to diversify your portfolio, but it’s not for everyone. Weighing the pros and cons will help you decide whether it’s the right investment for you.

Pros

• High yields: While junk bonds are highly volatile, they historically offer higher interest rates than other fixed-income debt securities.
• Bonds may appreciate if an issuer’s financial situation improves: If the issuer is actively paying down its debt, junk bonds may appreciate as the company’s credit rating improves.
• Diversification: Bonds are a great way to diversify your investment portfolio. While they have greater risk than investment-grade bonds, they’re not as risky as individual stocks.

Cons

• High default rates: Junk bonds typically have a high default rate than investment-grade bonds because they’re issued by companies that are not in good financial shape
• Liquidity risk: Because junk bonds tend to trade infrequently and often have few buyers, liquidity levels can be poor, making it difficult to sell them quickly should you need cash fast.
• Volatility risk: The values of high-yield bonds can fluctuate significantly as prevailing junk bond market conditions change. For example, if a bond’s credit rating is lowered, the value goes down, and vice versa.

Are Junk Bonds a Good Investment Now?

Whether you should invest in junk bonds depends on your financial situation and goals. If you’re willing to risk losing some of your investment in exchange for a higher yield, then high-yield bonds could be a good option.

However, it’s important to remember that even though high-yield bonds can offer greater returns than other debt securities, they also come with much higher risks. It’s, therefore, essential to research each bond thoroughly before investing and ensure you understand the issuer’s creditworthiness and any potential downsides of investing in the bond. In addition, you should spread out your investments across different issuers to diversify your portfolio and mitigate any significant losses if one bond issuer defaults or goes bankrupt.

Overall, junk bonds can be a great way to diversify your portfolio and increase returns, but it’s essential to understand the risks associated with them before investing. With careful research and due diligence, investing in junk bonds can be a smart move for investors looking to maximize their ROI while minimizing risk.