Junk! Junk is something futile, right? Something you want to toss in the trash? Well “junk bonds” are definitely not useless.
Let’s first understand what bonds are:
Bonds are debt instruments. Debt instruments are fixed income assets that allow the lender (person who lends/gives the money) to earn a fixed interest. The lender gets back the principal and interest on the maturity date.When you buy a bond, you are lending your money to someone (the government or a private company) who promises to pay you back the money (principle) when the bond matures, plus the interest. The ability of the bond issuer to meet its obligation is expressed in the bond’s credit rating. Whether a company defaults on its bonds or not totally depends on its ability to pay back its debt.
Bonds can be of two types:
I. Investment-grade bonds
II. Junk bonds/ Non-Investment grade bonds
Bonds that have a high credit rating are known as investment-grade bonds. These bonds are safer than the other bonds because the resources of the issuers are sufficient to indicate a good capacity to repay its obligations.
Bonds that are likely to default are called junk bonds or non-investment grade. Junk bonds may be issued by companies without long track records or by companies that have less than stellar credit rating. Since the risk associated with junk bonds is high, they offer higher returns.
Thus because of the very high interest rates these bond are also referred to as high-yield bonds. Junk bonds are typically rated ‘BB’ or lower whereas investment grade bonds are rated ‘BBB’ or higher. Since these junk bonds have a high default risk, they are speculative. Default risk is the chance that a company or government will be unable to pay its obligations when the bonds mature.
Stock like Characteristics
Junk bonds are an investment that has some characteristics of bonds and some of stocks. Let’s dig in deeper and understand this!
When you buy a bond, you’re a lender and you get predictable interest and your principal back when the term is over. On the other hand, when you invest in stocks, you’re an owner since you own a percentage of a company and also share a proportional part of the company’s earnings and dividends.
Bonds are paying minimal and have their own sets of risks. Bonds pay investors a regular fixed income, and their prices are much less volatile than those of stocks. Stocks are volatile as they are subject to various risks like market risk, inflation risk and liquidity risk. Since stocks have greater volatility they also give higher returns.
Thus we see that high-yield bonds (junk bonds) serve a role in between of stocks and bonds.
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