Junk bonds are also referred to as non-investment grade bonds or speculative-grade bonds. Companies that offer these bonds tend to have lower credit ratings with larger debt burden or weaker ability to meet their debts.
Most investors do not invest in junk bonds, however, junk bonds do have their own potential benefits and appeal. These 3 characteristics will help you determine if a bond is a junk bond.
#1 Investment Grade
Bonds are given ratings that indicate their credit quality. This is done by bond rating companies such as Moody’s, Fitch and Standard & Poor’s. A bond is considered investment grade if its credit rating is BBB- or higher. Junk bonds have a credit rating of BB or lower by rating agencies.
Junk bonds have the potential to increase their credit ratings when the company’s financial performance improves. This leads to the increase in the price of the junk bond, making it profitable for investors.
#2 High Yields
Junk bonds have higher yields than investment grade bonds. This is the main reason why people invest in junk bonds even though they are very volatile and risky.
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#3 High Risk
Of course, with high yield comes high risk. Junk bonds have a higher risk of defaulting – failure to pay interest/payments/principal when due (when bond matures). Their high risk of defaulting is due to multiple reasons such as the uncertainty of cash inflows, business having weak assets, over leveraging and many more.
Due to the high risk associated with junk bonds, the high yield is crucial in attracting investors as it serves as a form of compensation for the risk investors are taking.
Depending on each risk-preference, junk bonds can serve as an instrument for diversification. Nonetheless, it is not wise to have a large portion of anyone’s portfolio to be filled with such investments.