What Are Junk Bonds? Pros, Cons, Ratings

Why Would a Person Invest in Junk Bonds?

Junk Bonds
Talk to your financial advisor before buying junk bonds. Photo: vgajic/Getty images

Definition: Junk bonds are corporate bonds that are high-risk and high-return. They have been rated as not investment grade by Standard & Poor's or Moody's because the company that issues them is not fiscally sound. Therefore, they tend to have the highest return, compared to other bonds, to compensate for the additional risk. That is why they are also called high-yield bonds.

The junk bond market gives you an early indication of how much risk investors are willing to take on.

If investors get out of junk bonds, that means they are becoming more risk averse and don't feel optimistic about the economy. That predicts a market correction, a bear market or a contraction in the business cycle.

On the other hand, if junk bonds are being bought, it means investors are becoming more confident about the economy and are willing to take on more risk. That forecasts a market upturn, a bull market or economic expansion. (Source: The Reformed Broker, What Are Junk Bonds Trying to Tell Us, August 21, 2013)

Ratings

Junk bonds are rated by Moody's and Standard & Poor's as being speculative. That means the company's ability to avoid default is outweighed by uncertainties. That includes the company's exposure to bad business or economic conditions.

A rating of Ba or BB is less speculative than a C rating. Most junk bonds are rated B. Here are the different ratings:

  • High Risk - Rated Ba or B by Moody's, and BB or B by Standard & Poor's. The company currently is able to meet payments, but probably won't if economic or business conditions worsen. That's because it's unusually vulnerable to adverse conditions.
  • Highest Risk - Rated Caa, Ca or C by Moody's, and CCC, CC or C by Standard & Poor's. Business and economic conditions must be favorable for the company to avoid default.
  • In Default - Rated C by Moody's and D by Standard & Poor's. These are currently in default.

Investors categorize junk bonds as either "Fallen Angels" or "Rising Stars." The former are bonds that were initially investment grade.

Credit agencies lowered the rating when the company's credit worsened. "Rising Stars" are junk bonds whose ratings were raised because the company's credit improved. They may eventually become investment grade bonds.

To compensate for the higher risk of default, junk bond yields are usually 4-6 points higher than those on comparable U.S. Treasury bonds, which are backed by the federal government. Junk bonds make up the debt of 95% of U.S. companies with revenues over $35 million, and 100% of the debt of companies with revenues lower than that. For example, familiar companies like U.S. Steel, Delta, and Dole Foods issue junk bonds. (Sources: NASDAQ, Everything You Need to Know About Junk Bonds. Creighton EDU, An Explanation of Junk Bond Ratings)

Advantages

Junk bonds can boost overall returns in your portfolio while avoiding the higher volatility of stocks. First, they offer higher yields than investment-grade bonds. Second, they have the opportunity to do even better if they are upgraded when the business does improves. Because of this, junk bonds are not highly correlated to other bonds.

Junk bonds are highly correlated to stocks but also provide fixed interest payments. Bondholders get paid before stockholders in case of bankruptcy.

Another advantage is that they are usually issued with 10-year terms (or less), and can be called after four to five years. Junk bonds perform best in the expansion phase of the business cycle. That's because the underlying companies are less likely to default when times are good, which reduces the risk. (Source: PIMCO, Investment Basics)

Disadvantages

If the business defaults, you'll lose 100% of your initial investment. That means you need to analyze the credit risk of each company. If you invest in high-yield mutual funds instead, the manager does that before purchasing any bonds.

Another disadvantage is that even credit-worthy companies can get caught by negative economic trends. They have the cash flow to pay their debts at existing interest rates. However, some of their colleagues default on their bonds.

This sends the interest rates skyrocketing  on all bonds in their industry. When it comes time to refinance, they can no longer afford the higher rates.

Junk bonds are vulnerable to interest rate increases. If the yield curve flattens, banks are less willing to lend. That's because they borrow on the short-term money markets and lend on the long-term bond and mortgage market. Speculative companies won't be able to refinance or issue new bonds. The prospect of the Fed raising rates in December threw investors into a panic mode. (Source: "Default Is Not in the Stars,"  The Economist, April 25, 2015.)

Why Would a Person Invest in Junk Bonds?

Junk bonds are a good investment for those who need the higher return, and can afford the higher risk. Even then, it's advisable to only buy them in the expansion phase of the business cycle. You could then take advantage of the higher return with the minimum amount of risk. Here's more about the Junk Bond Market.

How to Buy Junk Bonds

You can purchase junk bonds either individually or through a high yield fund through your financial adviser. Funds are the best way to go for the individual investor because they are run by managers with the specialized knowledge needed to pick the right bonds. Keep in mind that many funds forbid you from withdrawing your investment for the first year or two. (Source: Investing in Bonds.com

Another way to invest is through junk bond exchange traded funds. The two biggest are HYG and JNK. 

History

In the 1780s, the new U.S. government had to issue junk bonds because the country's risk of default was high. In the early 1900s, junk bonds returned to finance the start-ups of companies that are well-known today: GM, IBM, and J. P. Morgan’s U.S. Steel.  After that, all bonds were investment grade until the 1970s, except for those that had become “fallen angels.” Any company that was speculative had to get loans from banks or private investors.

In 1977, Bear Stearns underwrote the first new junk bond in decades. Drexel Burnham then sold seven more junk bonds. In just six years, junk bonds more than a third of all corporate bonds.

Why? The main reason was research published by W. Braddock Hickman, Thomas R. Atkinson, Orin K. Burrell, that showed junk bonds offered much more return than was necessary for the risk. Drexel Burnam's Michael Milken used this research to build a huge junk bond market, which grew from $10 billion in 1979 to $189 billion in 1989. During this decade of economic affluence, junk bond yields averaged 14.5% while default were just 2.2%.

However, Milken and Drexel Burnham were brought down by Rudolph Giuliani and financial competitors that had previously dominated corporate credit markets against the high-yield market resulted in a temporary market collapse and the bankruptcy of Drexel Burnham. Almost overnight, the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year. The junk bond market didn't return until 1991. (Source: Glenn Yago, Library of Economics and Liberty, Junk Bonds)

Junk bond purchases took off in the summer of 2013 in response to the Fed's announcement it would begin tapering Quantitative Easing. That meant the Fed would buy fewer Treasury notes, a signal that it was reducing its expansive monetary policy and that the economy was getting better. As a result, interest rates on Treasurys and investment-grade bonds rose, as investors started selling their holdings before everyone else did.

Where did the money go? A lot went to junk bonds because investors saw the return was worth the risk. Since the economy was getting better, it meant the companies were less likely to default.

Demand was so high that banks started packaging these junk bonds and reselling them as collateralized debt obligations. These are derivatives backed by the bundle of loans. They helped worsen the 2008 financial crisis because the companies defaulted on the loans when the economy started to falter.

As a result, few banks sold them until 2013. That's when demand for junk bonds increased. Banks also needed the extra capital to meet Dodd-Frank requirements. (Source: Housing Wired, Junk Bonds the Penicillin for Fed Tapering, August 19, 2013)

Between 2009 and 2015, the U.S. junk bond market rose 80% to $1.3 trillion. Energy junk bonds rose 180% during that period to $200 million. Investors took advantage of low-interest rates to pour money into shale oil technology. As a result, energy companies comprised 16% to 20% of the high-yield bond market

Oil prices plummeted in 2014, catching many U.S. shale oil drillers off-guard. By September 2015, more than 15% of high-yield bonds were at "distressed" levels. That means they could default in the next nine months. The companies that issue them are having trouble getting loans or refinancing the bonds. The value of the bonds has fallen so far that investors require an interest rate 10% higher than U.S. Treasuries. (Source: "The Big Number," WSJ, September 29, 2015)

On December 12, 2015, Third Avenue Focused Credit Fund closed after losing 27% during the year. It halted redemptions to avoid a fire sale. Instead, it promised to pay shareholders a more fair value on December 16. This shocked markets, as it could happen to other hi-yield fund investors. The sell-off continued. (Source: "Third Avenue Credit Fund Closes," Barron's, December 12, 2015.)

Another problem is that emerging market companies issued many high-yield bonds in U.S. dollars. The dollar's 25% rise means their debt repayments are that much more expensive. That's a big problem for countries, like Turkey, that don't have enough dollars in their foreign exchange reserves. To make things worse, many of these countries export commodities. Those prices dropped significantly in the past two years. (Source: "Fed Can't Duck the Buck's Strength," WSJ, February 3, 2016.)

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