What Is A Junk Bond?
Junk bonds are debt securities issued by corporations with poor credit ratings, which means they yield more than investment-grade bonds because of their greater risk of default. Junk bonds are also known as high-yield or non-investment-grade bonds.
Junk bonds are generally classified as having credit ratings below Baa by Moody's Investors Services and BBB by S&P Global Ratings and Fitch Ratings, the three main credit rating agencies.
Advantages And Disadvantages Of Junk Bonds
In addition to their higher yield, junk bonds have some advantages over investment-grade bonds. For one thing, junk bonds historically correlate better with stocks rather than high-grade bonds but are generally less volatile than stocks, although they are more volatile than high-grade bonds. Since they carry high coupons, they yield more than dividend stocks without excessive risk.
A major disadvantage of owning junk bonds is that they default much more often than investment-grade bonds.According to S&P Global's 2018 Annual Global Corporate Default and Rating Transition Study, which tracked corporate bond performance over a period of more than 30 years, the highest one-year default rate for bonds rated BB, B, and CCC/C were 4.22%, 13.84%, and 49.28%, respectively. By comparison, the highest one-year default rates for bonds rated AAA, AA, A, and BBB were 0%, 0.38%, 0.39%, and 1.02%, respectively.
Investors can compensate for that risk by buying mutual funds and exchange-traded funds (ETFs) that invest in junk bonds, which have diversified portfolios of bonds managed by professional bond managers and credit risk experts.
Rising Stars and Fallen Angels
Junk bonds are generally grouped into two categories, although both have similar risks.
"Rising stars" are companies that have below investment-grade ratings often due to their relative youth and unproven track records. For example, Tesla, the electric vehicle manufacturer, is rated B2 by Moody's. It is rated B-plus by S&P.
Bonds of rising stars offer investors the opportunity to benefit both from high coupon payments as well as the possibility of credit upgrades, which often results in higher secondary market prices. The company may not be able to live up to its promises, so it may retain its junk status and possibly even default.
"Fallen angels" are companies that were formerly investment-grade but have had their credit ratings reduced to junk status. For example, Ford's credit rating was reduced to junk status, or Ba1, by Moody's in September 2019. Likewise, S&P downgraded the auto giant to BB from BBB on 23 March 2020.
Coincidentally, on that same day, the U.S. Federal Reserve said it would buy U.S. corporate bonds for the first time through the newly created Secondary Market Corporate Credit Facility (SMCCF), including "fallen angels." The Fed said it would buy investment-grade corporates as well as bonds that had been investment grade as of 22 March but had their ratings lowered as a result of the coronavirus pandemic and economic shutdown.
Investors buy fallen angels believing that the bonds may return to investment-grade status, which would raise their secondary market prices. However, some fallen angels are on a permanent downslope regardless of economic conditions and may never return to their former status.
Junk bonds, also known as high-yield or non-investment-grade bonds, are debt securities issued by corporations with poor credit ratings. These bonds yield more than investment-grade bonds but also carry higher risk due to their greater propensity to default.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…