We are explaining junk bonds in this article, but without any jargon.
Recently, the U.S-based cryptocurrency exchange Coinbase raised $2 billion via junk bonds. Sources told Bloomberg that the debt sale saw high demand from investors, with at least $7 billion of orders pouring in. Due to the high demand, Coinbase was able to increase the deal’s size from $1.5 billion to $2 billion.
Sources also told Bloomberg; equal amounts of seven-year-old bonds were sold at an interest rate of 3.375% while 10-year-old bonds were sold at an interest rate of 3.625%. Sources added that these interest rates were lower than the initially discussed borrowing costs.
When we hear the term ‘junk’, we might think of something that should be thrown away from our houses. But the meaning of junk bonds is completely different. Like all bonds, a junk bond is a type of debt security. The party buying the bond is essentially loaning money to the party issuing the bond. In return, the issuer promises to repay the money after a certain period, along with interest payments along the way. Officially known as high-yield bonds, junk bonds receive a low rating, or grade, from the credit rating agencies.
Historically, junk bonds have served the purpose of raising funds for financially weaker companies. At the same time, junk bonds also give higher returns to investors when compared to other debt securities like U.S. Treasury bonds, or corporate bonds issued by stronger, bigger companies.
Rating Junk Bonds
The higher the rating, the more likely the company will make the interest payments on time, and repay investors in full when the bond falls due. The lower the rating, the less likely the firm is to pay back, and this will result in the default of the bond and leaving its investors with worthless paper.
Moody’s, Standard & Poor’s (S&P), and Fitch assign letter ratings to companies and the bonds they issue, based on an analysis of their assets, underlying financial circumstances, and credit history. Below are the range of credit ratings given to junk bonds:
· High Risk: These junk bonds are rated Ba or B by Moody’s, and BB or B by S&P. This means that the company currently can meet payments. However, if economic or business conditions worsen, the company might not be able to meet the payments. This is because these companies are unusually vulnerable to adverse conditions.
· Highest Risk: These bonds are rated Caa, Ca or C by Moody’s, and CCC, CC, or C by S&P. In order for these companies to avoid default, business and economic conditions must be favourable.
· In Default: These bonds are rated C by Moody’s and D by S&P.
Why Are They Appealing?
· Higher Income: As indicated by a 2019 research paper from Vanguard, while junk bonds can be more volatile, they generally outperform investment-grade corporate bonds. This makes them attractive to investors who are looking for a higher regular income from their assets.
· Speculative Opportunity: Junk bonds can be bought during economic or market downswings and sold during upswings. By purchasing them cheap and then selling when they present less of a risk, investors can potentially make a profit.
· Hedging Strategy: Junk bonds can be bought as part of a hedging strategy that tries to balance risk across investments.
· Lower credit ratings indicate a greater risk of default or bankruptcy at the issuing company, particularly if the economic condition worsens.
· If the bond’s rating is lowered, future buyers will demand a higher yield, forcing down the bond’s market price.
Should You Buy It?
Junk bonds are a considerable part of the bond market. But for many individual investors, they might not be the right investment option. However, if you have a high appetite for risk, then you can consider having junk bonds in your portfolio. At the end of the day, invest carefully, and make sure you understand the risks before buying any junk bond.