Junk Bonds as a Risky, Attractive Investment Instrument
A junk bond is a non-grade investment instrument that promises high yields. It has a rating of BA or BB and is a risky investment that is likely to default.
Non-grade vs. Investment-grade Instruments
People who invest in bonds lend money to businesses, municipalities, and government agencies. Investors earn interest and get their money back at maturity. The credit rating of the debt instrument reflects the ability of the issuer to repay the money. Debt securities that are likely to default offer a high interest rate, but they are risky and speculative. This means that the government, entity, or company will be unable to meet its debt obligations. In contrast, investment-grade bonds with a high rating are safe but offer a modest interest rate. Note that debt securities may keep some of their value in case of default. It is important to inquire about the loss rate, which is different from the original price. There are different reasons for the price to decrease. For example, a business may change its product line or strategic location. Bankruptcy and insolvency are other reasons.
Investing and Credit Rating
The credit rating of a company is the main factor to consider. It helps in determining whether a debt security is a good investment. The credit agencies look at factors such as payments to suppliers, secured and unsecured loans, net income, and other information. The credit rating of a company reflects its ability to repay debt. At the same time, firms with good financial strategies, practices, and management also offer investment-grade bonds. Poor credit is not the only factor that plays a role. Other factors to look into are the state of the economy, asset value, and the profitability of companies. Investors who buy junk bonds take into account factors such as the issuer, the time of repayment, and the maturity date. There is also market, maturity, liquidity, currency, and inflationary risk to look into. Interest rate risk plays an important role. The value of the bond may decrease as a result of interest rate fluctuations. The interest rate structure may change as well. Credit risk refers to the probability or risk of default. In this case, the issuer will be unable to make interest or principal payments.
Bond rating is also an important factor. Investors should check how a debt security is classified:
• D – In default
• CCC – Highest risk
• BB – High risk
• BBB – Medium risk
• A – Low risk
• AA – Low risk
• Investment – Lowest risk
High-risk debt securities fall in two main categories – rising stars and falling angels. The first type is issued by companies that have an improvement in their credit rating. Fallen angels are offered by companies that have experienced a decrease in their credit quality.
Companies with compromised credit issue junk bonds because they have a more limited access to financing. Banks often offer loans with a very high interest rate, which makes borrowing a very expensive option. This is why, companies with poor credit issue debt securities to raise capital. To attract investors, they offer yields that are 4 – 6 percent higher than those of other securities. Because of the high risk involved, novice investors usually opt for other, safer investment instruments or use the services of a broker. Another option is to include junk bonds in an investment portfolio. This helps to diversify the portfolio while the presence of different types of assets lowers the risk of loss. Another advantage is that high-risk securities trade in the secondary market. This means that they provide a degree of liquidity.
Alternative Investment Instruments
Investors can choose from a large variety of solutions and instruments, including government and municipal debt securities. There are revenue, zero coupon, callable, convertible, contribution, and subsidy bonds. Depending on the country of residence, investors can choose from index-linked, financing, treasury, yield, and other types of bills and debt securities.
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