Junk bonds are simply one of the MANY investments that you could have.There are a LOT of different investments out there. And all of those investments can satisfy any investment appetite that one may have. Junk bonds are just one of those investments. And you can decide if you want to pursue it or not.
What are Junk Bonds?
Junk bonds are not necessarily “junk”. However, they are not great either.
Junk bonds are bonds with a low credit rating. The credit ratings of bonds are set primarily by three organizations:
- Moody’s
- Standard and Poor (S&P)
- Fitch
Each of these ratings organizations assigns a creditworthiness grade to each bond (as well as other organizations as well).
Here is what each of these company’s rating systems look like from best credit rating to worst:
| Moody’s | S&P | Fitch |
| Investment Grade | Investment Grade | Investment Grade |
| Aaa | AAA | AAA |
| Aa1 | AA+ | AA+ |
| Aa2 | AA | AA |
| Aa3 | AA- | AA- |
| A1 | A+ | A+ |
| A2 | A | A |
| A3 | A- | A- |
| Baa1 | BBB+ | BBB- |
| Baa2 | BBB | BBB |
| Baa3 | BBB- | BBB- |
| Junk Bonds | Junk Bonds | Junk Bonds |
| Ba1 | BB+ | BB+ |
| Ba2 | BB | BB |
| Ba3 | BB- | BB- |
| B1 | B+ | B+ |
| B2 | B | B |
| B3 | B- | B- |
| Caa1 | CCC+ | CCC+ |
| Caa2 | CCC | CCC |
| Caa3 | CCC- | CCC- |
| D | D |
Bonds are typically pooled into two main groups:
- Investment grade bonds
- Junk bonds
In the chart above, the investment grade bonds are at the top and the junk bonds are at the bottom
Still a little confused? Think of it like this.
Each of us has a credit score. These credit scores range from 850-300.
850 is really awesome, while 300 sucks.
What a credit score is is a measure of creditworthiness. Just like the credit rating of bonds.
A person with an 800 credit score is much more worthy of a loan with better terms than a person with a credit score of 550.
The person with an 800 credit score might have to pay 5% interest on a loan while the person with a 550 credit score might have to pay 18%.
Bonds work the same way.
When a bond pays interest to the bondholder it pays it based on the risk that the bond carries. A bond that is labeled a junk bond will have a much higher interest rate than one that is an investment bond. That is because there is a lot less risk of default in a bond with a credit rating that is in the green (investment bonds) than one that is listed in the red (junk bonds).
For example:
Mike is trying to decide which of two bonds to invest in. The bonds are completely the same except that the credit rating is different.
The credit rating with Bond #1 is an AA rating (S&P) and the credit rating with Bond #2 is a B rating (S&P again).
Bond #1 has an interest rate (often called a coupon) of 3.5%.
Bond #2 has a coupon rate of 7%.
This is because Bond #2 is much more risky and thus deserves a higher payout to the investor.
Positives of Junk Bonds
The biggest positive that there is with junk bonds is the higher coupon rate that they pay. Plain and simple.
This is why people invest in them.
However, when you invest in junk bonds you have to be prepared for that investment to not do so well since there is more risk with them.
Just like a bank who lends money to someone with a really low credit score. Yes, the bank would earn more interest from that person. But there is a higher chance that the car will have to be repossessed from that person than someone with a really high credit score.
Another positive of junk bonds is that sometimes a company’s credit rating is brought down for a number of reasons, bad investments, late debt payments, defaults, etc.
Sometimes, when this happens the company will restructure. They might higher a new board or CEO. They might file Chapter 11 bankruptcy. And sometimes they will climb back out of the junk bond category and into the investment category.
And if you have older bonds that are considered “junk” they will still pay the higher interest rate even though the company is now rated at a higher credit rating.
Drawbacks of Junk Bonds
The biggest drawback of junk bonds is that they are at higher risk of default. In the event of a company/organizational default, you may not be repaid your original principal.
This is technically a risk for ALL organizations (companies, municipalities, and even countries). But this is why the rating system exists. To help quantify the likelihood of default happening.
Final Thoughts
Junk bonds are simply one more form of investment. They are something that some people like to invest in and others do not. They are included in some retirement funds and not included in others.
But if you decide to invest in this product, make sure you know what you are getting into. Yes, you will have a higher rate of return. But that doesn’t come without the risk.
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